Exam 2 : Chapter 4: Cash and Internal Controls, Chapter 5: Receivables and Sales, Chapter 6: Inventory and Cost of Goods Sold, Chapter 7 long-term assets

Accountants often call FIFO the

balance-sheet approach: The amount it reports for ending inventory (which appears in the balance sheet) better approximates the current cost of inventory. The ending inventory amount reported under LIFO, in contrast, generally includes "old" inventory costs that do not realistically represent the cost of today's inventory.

The downside of extending credit to customers

not all customers will pay fully on their accounts. Even the most well-meaning customers may find themselves in difficult financial circumstances beyond their control, limiting their ability to repay debt. Customers' accounts that we no longer consider collectible are uncollectible accounts, or bad debts.

In the uncommon event that the two balances at the end of the bank reconciliation schedule are not equal For example, suppose a company is unable to account for $100 of missing cash

management investigates the discrepancy to check for wrongdoing or errors by company employees or the bank. If the company cannot resolve the discrepancy, it records the difference to either Miscellaneous Expense or Miscellaneous Revenue, depending on whether it has a debit or credit balance. For example, suppose a company is unable to account for $100 of missing cash. In this event, the company records the following transaction, increasing Miscellaneous Expense and decreasing Cash. Journal: debit miscellaneous Expense 100 Credit cash 100

manufacturing companies

manufacture the inventories they sell, rather than buying them in finished form from suppliers. Apple Inc., Coca-Cola, Harley-Davidson, ExxonMobil, Ford, Sony, and Intel are manufacturers. Manufacturing companies buy the inputs for the products they manufacture.

companies that earn revenue by selling inventory

manufacturing or merchandising companies

Employee purchases should be included in the

accounting records by the end of the reporting period. Employee purchases made with debit cards and checks will be captured in the accounting records at the time the bank reconciliation is prepared, like we saw in the previous section. In this section, we discuss how to account for employee purchases using credit cards and the petty cash fund. Those expenditures typically are not immediately recorded in the accounting records, yet they are legitimate business transactions during the period.

inventory is also referred to as

merchandise inventory

type of cash flow and inflow or outflow: purchase equipment with a note payable

not reported as cash flow because no cash is involved in the transaction

aging method

n our example for Kimzey Medical Clinic, we estimated future uncollectible accounts by applying a single estimated percentage to total accounts receivable (30%). Management can estimate this percentage using historical averages, current economic conditions, industry comparisons, or other analytical techniques. A more accurate method than assuming a single percentage uncollectible for all accounts is to consider the various ages of individual accounts receivable, using a higher percentage for "old" accounts than for "new" accounts. This is known as the aging method. For instance, accounts that are 120 days past due are older than accounts that are 60 days past due. The older the account, the less likely it is to be collected Using the aging method to estimate uncollectible accounts is more accurate than applying a single percentage to all accounts receivable. The aging method recognizes that the longer accounts are past due, the less likely they are to be collected.

We recognize accounts receivable as assets in the balance sheet and report them at their....

net realizable value, that is, the amount of cash we expect to collect.

Even though the seller does not receive cash at the time of the credit sale, the firm

records revenue immediately once goods or services are provided to the customer and future collection from the customer is probable.

Net revenues (or net sales)

refer to a company's total revenues less any amounts for discounts, returns, and allowances. We discuss these items next.

The direct write-off method is primarily used for

tax reporting. Companies do not report a tax deduction for bad debts until those bad debts are actually uncollectible.

Two important ratios that help in understanding the company's effectiveness in managing receivables

the receivables turnover ratio and the average collection period.

occupational fraud

the use of one's occupation for personal enrichment through the deliberate misuse or misapplication of the employer's resources

we can classify merchandising companies as what two thing

wholesalers or retailers Wholesalers resell inventory to retail companies or to professional users. For example, a wholesale food service company like Sysco Corporation supplies food to restaurants, schools, and sporting events but generally does not sell food directly to the public. Also, Sysco does not transform the food prior to sale; it just stores the food, repackages it as necessary, and delivers it. Retailers purchase inventory from manufacturers or wholesalers and then sell this inventory to end users. You probably are more familiar with retail companies because these are the companies from which you buy products. Best Buy, Target, Lowe's, Macy's, Gap, Sears, and McDonald's are retailers. Merchandising companies typically hold their inventories in a single category simply called inventory.

From the statement of cash flows, investors know a company's cash inflows and cash outflows related to

(1) operating activities, (2) investing activities, and (3) financing activities.

we classify inventory for a manufacturer into three categories:

(1) raw materials, (2) work in process, and (3) finished goods: Raw materials inventory includes the cost of components that will become part of the finished product but have not yet been used in production. Work-in-process inventory refers to the products that have been started in the production process but are not yet complete at the end of the period. The total costs include raw materials, direct labor, and indirect manufacturing costs called overhead. Finished goods inventory consists of items for which the manufacturing process is complete.

-Operating activities -investing activities -financing activities

- include cash transactions involving revenue and expense events during the period. In other words, operating activities include the cash effect of the same activities that are reported in the income statement to calculate net income. - include cash investments in long-term assets and investment securities. When the firm later sells those assets, we consider those transactions investing activities also. So, investing activities tend to involve long-term assets. - include transactions designed to raise cash or finance the business. There are two ways to do this: borrow cash from lenders or raise cash from stockholders. We also consider cash outflows to repay debt and cash dividends to stockholders to be financing activities. So, financing activities involve liabilities and stockholders' equity.

Operating income: -operating expenses -operating income

-After gross profit, the next items reported are Selling, general, and administrative expenses, often referred to as operating expenses. We discussed several types of operating expenses in earlier chapters—advertising, salaries, rent, utilities, supplies, and depreciation. These costs are normal for operating most companies. Best Buy has total operating expenses of $7,597 million, and like most companies, does not list individual operating expense amounts in the income statement. -Gross profit reduced by these operating expenses is referred to as operating income (or sometimes referred to as income from operations). It measures profitability from normal operations, a key performance measure for predicting the future profit-generating ability of the company.

Income before income taxes: -nonoperating revenues and expenses -Best Buy reports two nonoperating revenues -nonoperating expenses most commonly include -income before income taxes

-After operating income, a company reports nonoperating revenues and expenses. Best Buy refers to these items as Other income (expense). Other income items are shown as positive amounts, and other expense items are shown as negative amounts (in parentheses). Nonoperating revenues and expenses arise from activities that are not part of the company's primary operations. -gain on the sale of investments and investment income. Gains on the sale of long-term assets (such as investments, land, equipment, and buildings) occur when assets are sold for more than their recorded amounts. Investment income includes earnings from dividends and interest. Nonoperating revenues are not typical operating activities, but they do represent a source of profitability, so they are included in the income statement. -Nonoperating expenses most commonly include interest expense. Best Buy reports interest expense of $90 million. Nonoperating expenses could also include losses on the sale of investments or long-term assets. Investors focus less on nonoperating revenues and expenses than on income from operations, because nonoperating activities often do not have long-term implications on the company's profitability. -Combining operating income with nonoperating revenues and expenses yields income before income taxes. For Best Buy, the amount of nonoperating expenses exceeds the amount of nonoperating revenues, so income before income taxes is lower than operating incom

what can be done to minimize fraud?

-At least one of the three elements of the fraud triangle must be eliminated. Of the three elements, companies have the greatest ability to eliminate opportunity. To eliminate opportunity, companies implement formal procedures known as internal controls. -internal controls: These represent a company's plan to (1) safeguard the company's assets and (2) improve the accuracy and reliability of accounting information. In this chapter, we'll discuss the basic principles and procedures of companies' internal controls (with a deeper look at cash controls). The quality of internal controls directly affects the quality of financial accounting.

-for practical reasons, most companies use one of the three inventory cost flow assumptions -assumptions

-FIFO, LIFO, or weighted-average cost—to determine cost of goods sold and inventory. - Note the use of the word assumptions: Each of these three inventory cost methods assumes a particular pattern of inventory cost flows. However, the actual flow of inventory does not need to match the assumed cost flow in order for the company to use a particular method.

LIMITATIONS OF INTERNAL CONTROL: -Collusion -Top-level employees -alone?

-Internal control systems are especially susceptible to collusion. Collusion occurs when two or more people act in coordination to circumvent internal controls. Going back to our movie theatre example, if the ticket cashier and the ticket taker, or the ticket cashier and the accountant, decide to work together to steal cash, theft will be much more difficult to detect. Fraud cases that involve collusion are typically several times more severe than are fraud cases involving one person. This suggests that collusion is effective in circumventing control procedures. -Top-level employees who have the ability to override internal control features also have opportunity to commit fraud. For example, managers may be required to obtain approval from the chief financial officer (CFO) for all large purchases. However, if the CFO uses the company's funds to purchase a boat for personal use at a lake home, fewer controls are in place to detect this misappropriation. Even if lower-level employees suspect wrongdoing, they may be unwilling to confront their boss about the issue. -Finally, because there are natural risks to running any business, effective internal controls and ethical employees alone cannot ensure a company's success, or even survival.

-receivables turnover ratio -what does the "net" in net credit sales come from -The amount for net credit sales is obtained from where

-Number of times during a year that the average accounts receivable balance is collected (or "turns over"). It equals net credit sales divided by average accounts receivable. -The "net" in net credit sales refers to total credit sales net of discounts, returns, and allowances (similar to net revenues calculated earlier in the chapter) -The amount for net credit sales is obtained from the current period's income statement; average accounts receivable equals the average of accounts receivable reported in this period's and last period's balance sheets. Last period's ending accounts receivable are this period's beginning accounts receivable. The more frequently a business is able to "turn over" its average accounts receivable, the more quickly it is receiving cash from its customers.

-average collection period -Companies typically strive for what

-The average collection period is another way to express the same efficiency measure. This ratio shows the approximate number of days the average accounts receivable balance is outstanding. It is calculated as 365 days divided by the receivables turnover ratio. -a high receivables turnover ratio and a correspondingly low average collection period. As a company's sales increase, receivables also likely will increase. If the percentage increase in receivables is greater than the percentage increase in sales, the receivables turnover ratio will decline (and the average collection period will increase). This could indicate that customers are dissatisfied with the product or that the company's payment terms for attracting new customers are too generous, which, in turn, could increase sales returns and bad debts.

-what type of debit balance does notes receivable have -how we classify notes receivable

-a normal debit balance like assets -we classify notes receivable as either current or noncurrent, depending on the expected collection date. If the time to maturity is longer than one year, the note receivable is a long-term asset. -

-Among all of the company's assets, _______ is the one most susceptible to employee fraud. -obvious and less obvious ways employees steal this

-cash -The obvious way that employees steal cash is by physically removing it from the company, such as pulling it out of the cash register and walking out the door. However, there are other, less obvious ways to commit fraud with a company's cash. An employee could falsify documents, causing the company to overpay the employee for certain expenses, to issue an inflated paycheck, or to make payment to a fictitious company. Because of these possibilities, companies develop strict procedures to maintain control of cash.

intangible assets not subject to amortization (those with indefinite useful life)

-goodwill -trademarks(with indefinite life0

Gross Profit: -what are typically the most inportant activities of a merchandising company? -sales of inventory are commonly reported as... -services provided are recorded as.... -net sales -cost of goods sold -gross profit

-inventory transactions for this reason, companies report the revenues and expenses directly associated with these transactions in the top section of a multiple-step income statement -sales revenue -service revenue -the net amount of revenues is commonly referred to as net sales -Next, the cost of inventory sold is reported as an expense called Cost of goods sold. -Net revenues (or net sales) minus cost of goods sold equals gross profit. Gross profit is the first level of profit shown in the multiple-step income statement. Gross profit provides a key measure of profitability for the company's primary business activities.

intangible assets subject to amortization (those with finite useful life)

-patents -copyrights -trademarks(with finite life) -franchises

COLLECTION OF NOTES RECEIVABLE -We record the collection of notes receivable the same way as collection of accounts receivable, except that -example: Continuing the previous example, suppose that on August 1, 2018, the maturity date, Justin repays the note and interest in full as promised. Kimzey will record the following.

-we also record interest earned as interest revenue in the income statement. Debit Cash 10600 credit notes receivable 10,000 credit interest revenue 600

Common controls over cash disbursements include:

1. Make all disbursements, other than very small ones, by check, debit card, or credit card. This provides a permanent record of all disbursements. 2. Authorize all expenditures before purchase and verify the accuracy of the purchase itself. The employee who authorizes payment should not also be the employee who prepares the check. 3. Make sure checks are serially numbered and signed only by authorized employees. Require two signatures for larger checks. 4. Periodically agree amounts shown in the debit card and credit card statements against purchase receipts. The employee verifying the accuracy of the debit card and credit card statements should not also be the employee responsible for actual purchases. 5. Set maximum purchase limits on debit cards and credit cards. Give approval to purchase above these amounts only to upper-level employees. 6. Employees responsible for making cash disbursements should not also be in charge of cash receipts.

In the following sections, we illustrate the three most common depreciation methods used in practice: straight-line, declining-balance, and activity-based.2 These three methods illustrate the basic differences in how depreciation estimates are made. They are important for different reasons. 1. straight-line 2. declining-balance 3. activity-based

1. Straight-line. This method simply takes an equal amount of depreciation each year. It is by far the most common depreciation method used in financial accounting. 2. Declining-balance. This method is an accelerated method, meaning that more depreciation expense is taken in the early years than in the later years of an asset's life. The concepts behind declining-balance are also used in calculating depreciation for tax purposes. 3. Page 336 Activity-based. This method calculates depreciation based on the use of the asset. For example, a vehicle can be depreciated based on the miles driven. It is commonly used to allocate the cost of natural resources.

We classify long-term assets into two major categories:

1. Tangible assets. Assets in this category include land, land improvements, buildings, equipment, and natural resources. Krispy Kreme's land, buildings, and equipment fall into this category. 2. Intangible assets. Assets in this category include patents, trademarks, copyrights, franchises, and goodwill. We distinguish these assets from property, plant, and equipment by their lack of physical substance. The evidence of their existence often is based on a legal contract. Google's copyrights are intangible assets.

the 5 components of internal controls

1. monitoring: continual monitoring of internal activities and reporting of deficiencies is required. Monitoring includes formal procedures for reporting control deficiencies 2. Control activities: the policies and procedures that help ensure that management's directives are being carried our. These activities include authorizations, reconciliations, and separation of duties 3. risk assessment: identifies and analyzes internal and external risk factors that could prevent a company's objectives from being achieved 4. the control environment sets the overall ethical tone of the company with respect to internal control. It includes formal policies related to management's philosophy, assignment of responsibilities, and organizational structure.

Reconciling the bank account involves three steps:

1.Reconcile the bank's cash balance. 2.Reconcile the company's cash balance. 3.Update the company's Cash account by recording items identified in Step 2.

The adjusting entries to record these estimated contra revenues at the end of the year can be somewhat complicated, so we leave them to a more advanced accounting course. For now, the important points to understand are:

1.Revenues are reported for the amount of cash a company expects to be entitled to receive from customers for providing goods and services. 2.Total revenues are reduced by sales discounts, sales returns, and sales allowances that occur during the year. 3.Total revenues are further reduced by an adjusting entry at the end of the year for the estimate of additional sales discounts, sales returns, and sales allowances expected to occur in the future but that relate to the current year.

four methods of inventory costing

1.Specific identification 2.First-in, first-out (FIFO) 3.Last-in, first-out (LIFO) 4.Weighted-average cost

Companies acquire intangible assets in two ways:

1.They purchase intangible assets like patents, copyrights, trademarks, or franchise rights from other companies. 2.They develop intangible assets internally, for instance by developing a new product or process and obtaining a protective patent.

interest calculation example: In the previous example, Kimzey accepted a six-month, 12% promissory note. The "12%" indicates the annual interest rate charged by the payee. The terms of the six-month note mean that Kimzey will charge Justin Payne one-half year of interest, or 6%, on the face value. Interest on Kimzey's note receivable is calculated as follows.

10,000 x 12% x 6/12=$600(interest)

COPYRIGHTS

A copyright is an exclusive right of protection given by the U.S. Copyright Office to the creator of a published work such as a song, film, painting, photograph, book, or computer software. Copyrights are protected by law and give the creator (and his or her heirs) the exclusive right to reproduce and sell the artistic or published work for the life of the creator plus 70 years. A copyright also allows the copyright holder to pursue legal action against anyone who attempts to infringe the copyright. Accounting for the costs of copyrights is virtually identical to that of patents.

PATENTS

A patent is an exclusive right to manufacture a product or to use a process. The U.S. Patent and Trademark Office grants this right for a period of 20 years. When a firm purchases a patent, it records the patent as an intangible asset at its purchase price plus other costs such as legal and filing fees to secure the patent. Filing fees include items such as the fee to record a patent with the U.S. Patent and Trademark Office. In contrast, when a firm develops a patent internally, it expenses the research and development costs as it incurs them. For example, major pharmaceutical companies like Amgen and Gilead Sciences spend over a billion dollars each year developing new drug patents. Most of these research and development costs are recorded as operating expenses in the income statement. An exception to this rule is legal fees. The firm will record in the Patent asset account the legal and filing fees to secure the patent, even if it developed the patented item or process internally. Holders of patents often need to defend their exclusive rights in court. For example, The J.M. Smucker Company obtained a patent on a round, crustless, frozen peanut butter and jelly sandwich sealed in an airtight foil wrapper, marketed under the name "Uncrustables." Smucker's later had to defend its patent by attempting to stop another company from making similar sandwiches. The costs of successfully defending a patent, including attorneys' fees, are added to the Patent account.

TRADEMARKS

A trademark, like the name Apple, is a word, slogan, or symbol that distinctively identifies a company, product, or service. The firm can register its trademark with the U.S. Patent and Trademark Office to protect it from use by others for a period of 10 years. The registration can be renewed for an indefinite number of 10-year periods, so a trademark is an example of an intangible asset whose useful life can be indefinite. Page 330 Firms often acquire trademarks through acquisition. As an example, Hewlett-Packard (HP) acquired all the outstanding stock of Compaq Computer Corporation for $24 billion, of which $1.4 billion was assigned to the Compaq trademark. Advertising costs can factor into the value of a trademark in a big way. For example, Apple has aired commercials featuring each new iPhone release. Certainly these ads benefited Apple. But what was the value to the company of the advertising? And for how many years will Apple receive that value? Since these items are so difficult to estimate, when a firm develops a trademark internally through advertising, it doesn't record the advertising costs as part of the cost of the intangible asset. Instead, it expenses the advertising costs in the income statement. Even though some advertising costs meet the definition of an asset by providing future benefits, due to the difficulty in estimating these amounts, financial accounting rules require advertising costs to be expensed as incurred. A firm can record attorney fees, registration fees, design costs, successful legal defense, and other costs directly related to securing the trademark as an intangible asset in the Trademark asset account. This is how Apple Inc. can have a trademark valued at $118.9 billion, but reported in the balance sheet for much less. The estimated value of the trademark is not recorded in the Trademarks account; instead, only the legal, registration, and design fees are recorded. The advertising costs that help create value for the trademark are recorded as advertising expense.

amortization.

Allocating the cost of property, plant, and equipment to expense is called depreciation. Similarly, allocating the cost of intangible assets to expense is called amortization.

Errors can be made either by the company or its bank and may be accidental or intentional.

An accidental error might occur if the company mistakenly were to record a check being written for $117 as $171 in its records, or if the bank improperly processed a deposit of $1,100 as a $1,010 deposit. An intentional error is the result of theft. If the company records a daily deposit of $5,000 but an employee deposits only $500 into the bank account and pockets the rest, the bank reconciliation will reveal the missing $4,500.

additions

An addition occurs when we add a new major component to an existing asset. We should capitalize the cost of additions if they increase, rather than maintain, the future benefits from the expenditure. For example, adding a refrigeration unit to a delivery truck increases the capability of the truck beyond that originally anticipated, thus increasing its future benefits.

LIFO adjustment

An adjustment used to convert a company's own inventory records maintained on a FIFO basis to LIFO basis for preparing financial statements.

improvements

An improvement is the cost of replacing a major component of an asset. The replacement can be a new component with the same characteristics as the old component, or a new component with enhanced operating capabilities. For example, we could replace an existing refrigeration unit in a delivery truck with a new but similar unit or with a new and improved refrigeration unit. In either case, the cost of the improvement usually increases future benefits, and we should capitalize it to the Equipment account.

bank reconciliation

Another important control used by nearly all companies to help maintain control of cash is a bank reconciliation. A bank reconciliation matches the balance of cash in the bank account with the balance of cash in the company's own records.

gross profit ratio

Another important indicator of the company's successful management of inventory is the gross profit ratio (also called gross profit percentage). It measures the amount by which the sale of inventory exceeds its cost per dollar of sales. We calculate the gross profit ratio as gross profit divided by net sales. (Net sales equal total sales revenue less sales discounts, returns, and allowances.) gross profit/net sales

BUILDINGS

Buildings include administrative offices, retail stores, manufacturing facilities, and storage warehouses. The cost of acquiring a building usually includes realtor commissions and legal fees in addition to the purchase price. The new owner sometimes needs to remodel or otherwise modify the building to suit its needs. These additional costs are part of the building's acquisition cost. Unique accounting issues arise when a firm constructs a building rather than purchasing it. Of course the cost of construction includes architect fees, material costs, and construction labor. New building construction likely also includes costs such as manager supervision, overhead (costs indirectly related to the construction), and interest costs incurred during construction.

INVENTORY PURCHASES AND SALES example: jan 1 transaction: beginning inventory details: 100 units for $7 each total cost: $700 Total revenue:- Apr 25 transaction: purchase details: 300 units for $9 each total cost: 2,700 total revenue: - Jul. 17 Transaction: sale detail: 600 units for $15 each total cost: - Total revenue: 4,500 oct 19 transaction: purchase details: 600 units for $11 each total cost: 6,600 total revenue: - Dec 15 transaction: Sale Details: 500 units for $15 each total cost: - Total revenue: 7,500 totals: total cost: 10,000 total revenue: 12,000 To record the purchase of new inventory, we debit Inventory (an asset) to show that the company's balance of this asset account has increased. At the same time, if the purchase was paid in cash, we credit Cash. Or more likely, if the company made the purchase on account, we credit Accounts Payable, increasing total liabilities. Thus, Mario records the first purchase of 300 units for $2,700 on April 25 as:

April 25 Debit inventory 2700 credit accounts payable 2700

In this case, the cost of freight is considered a cost of the purchased inventory. When Mario pays $300 for freight charges associated with the purchase of inventory on April 25, those charges would be recorded as part of the inventory cost.

April 25 debit inventory 300 credit cash 300 Later, when that inventory is sold, those freight charges become part of the cost of goods sold. In Mario's case, all of the units purchased on April 25 are sold by the end of the year, so the $300 freight charge would be reported as part of cost of goods sold in the income statement at the end of the year.

REPORTING THE LIFO DIFFERENCE

As Mario's Game Shop demonstrates, the choice between FIFO and LIFO results in different amounts for ending inventory in the balance sheet and cost of goods sold in the income statement. This complicates the way we compare financial statements: One company may be using FIFO, while a competing company may be using LIFO. To determine which of the two companies is more profitable, investors must adjust for the fact that managers' choice of inventory method has an effect on reported performance. Because of the financial statement effects of different inventory methods, companies that choose LIFO must report the difference in the amount of inventory a company would report if it used FIFO instead of LIFO. (This difference is sometimes referred to as the LIFO reserve.) For some companies that have been using LIFO for a long time or for companies that have seen dramatic increases in inventory costs, the LIFO difference can be substantial. For example, Illustration 6-11 shows the effect of the LIFO difference reported by Rite Aid Corporation, which uses LIFO to account for most of its inventory. If Rite Aid had used FIFO instead of LIFO, reported inventory amounts would have been $998 million greater and $1,019 million greater in 2015 and 2014, respectively. The magnitude of these effects can have a significant influence on investors' decisions.

STEP 3: UPDATE THE COMPANY's CASH ACCOUNT problem: Six cash transactions recorded by First Bank are not reported in Starlight's cash records by the end of March: 1.Note received by First Bank on Starlight's behalf ($3,000, which equals $2,800 plus related interest received of $200). 2.Interest earned by Starlight on its bank account ($20). 3.NSF check ($750). 4.Debit card purchase of office equipment by an employee ($200). 5.Electronic funds transfer (EFT) related to the payment of advertising ($400). 6.Service fee ($50).

As a final step in the reconciliation process, a company must update the balance in its Cash account, to adjust for the items used to reconcile the company's cash balance (Step 2). We record these adjustments once the bank reconciliation is complete. Remember, these are amounts the company didn't know until it received the bank statement. We record items that increase the company's cash with a debit to Cash. We credit Notes Receivable because the company has collected cash from the note, decreasing that asset account (−$2,800). We also credit Interest Revenue for interest earned from the note ($200) plus interest earned on its bank account ($20). Journal Entry for items that increase the company's cash: Debit Cash 3020 Credit notes receivable 2800 Credit interest revenue(from note) 200 Credit interest revenue(from bank account) 20 Journal Entry for items that decrease the company's cash: Debit accounts receivable 750 Debit Equipment 2000 Debit Advertising Expense 400 Debit Service Fee Expense 50 Debit rent expense 300 Credit cash 1700 (Accounts Receivable is debited in order to increase that asset account (+$750), to show that the customer who paid with an NSF check still owes the company money. The other debits are needed to record the items related to cash outflows—equipment purchased and expenses incurred.)

straight-line method

By far the most easily understood and widely used depreciation method is straight-line. With the straight-line method we allocate an equal amount of the depreciable cost to each year of the asset's service life. The depreciable cost is the asset's cost minus its estimated residual value. Depreciable cost represents the total depreciation to be taken over the asset's useful life. To calculate depreciation expense for a given year, we simply divide the depreciable cost by the number of years in the asset's life depreciation expense=(assets cost-residual value)/service life

petty cash fund

Cash on hand to pay for these minor purchases is referred to as a petty cash fund, and the employee responsible for the fund is often referred to as the petty cash custodian. an office manager might decide to have a lunch meeting for the staff and needs actual cash available to pay for pizza delivery.

During May, the petty cash custodian provides cash to employees for an office lunch and package delivery and places vouchers documenting the purposes of those expenditures in the petty cash fund. In addition, the purchasing manager and the marketing manager used their credit cards for expenditures related to their positions. Suppose the following items and amounts occur(pretend its in a chart): petty cash fund (cash): lunch: $60 delivery: $90 Purchasing manager (Credit card) supplies: $800 supples: $600 Marketing MAnager (credit card): Advertising: $1500 Postage: $1200 - Also at the end of the period, the $200 petty cash fund needs to be replenished. Cash of $150 has been disbursed during May ($60 for lunch and $90 for delivery). The fund has only $50 remaining, so management withdraws an additional $150 from the bank to place in the fund. The fund's physical balance will once again be $200.

At the end of May, the company's accountant collects vouchers from the petty cash fund and credit card receipts from the purchasing manager and marketing manager. The expenditures above are recorded in the company's records. Journal: debit entertainment expense 60 debit delivery expense 90 debit supplies (800+600) 1400 debit advertising expense 1500 debit postage expense 1200 credit petty cash 150 credit accounts payable 4100 The expenditures made with petty cash reduce the petty cash fund. The expenditures made with credit cards are not paid immediately, so they are recorded as Accounts Payable until paid. If the company's accountant decides to pay the credit card balance at the time of reconciliation, then the $4,100 credit would be to Cash. Journal: debit petty cash 150 credit cash 150

STEP 2: RECONCILE THE COMPANY's CASH BALANCE: Next, we need to reconcile the company's cash balance. What are some examples of cash transactions recorded by the bank but not yet recorded by the company? Here are some common items that will increase the company's cash balance once the reconciliation occurs.

Bank collections on the company's behalf offer a convenient and safer way for the company to collect cash. With the increase in electronic banking, these types of cash collections are becoming increasingly popular, especially in certain business settings such as recurring payments from customers, real estate transactions, collection agencies, and lending arrangements. Companies may also earn interest based on the average daily balance of their checking or savings account. Other items in the reconciliation will decrease the company's cash balance. NSF checks occur when customers' checks are written on "nonsufficient funds." In other words, the company receives a customer's check and deposits that check, recording an increase in cash. However, the company later finds out from the bank statement that the customer's check was "bad," and the company then needs to decrease its cash balance to undo the initial increase. Employees sometimes use debit cards to make purchases. These purchases are immediately withdrawn from the bank account, but they may not be known by the company's accountant until examination of the bank statement. Electronic funds transfers (EFTs) are automatic transfers from one bank account to another (sometimes referred to as electronic checks or e-checks). For example, a company may pay its mortgage or utility bill by having it automatically withdrawn from its bank account. Banks charge service fees for various activities related to monthly maintenance, overdraft penalties, ATM use, wire transfers, foreign currency exchanges, automatic payments, and other account services. These fees may not be known by the company until examination of the bank statement.

LAND IMPROVEMENTS

Beyond the cost of the land, Olive Garden likely will spend additional amounts to improve the land by adding a parking lot, sidewalks, driveways, landscaping, lighting systems, fences, sprinklers, and similar additions. These are land improvements. Because land improvements have limited useful lives (parking lots eventually wear out), and land has an unlimited useful life, we record land improvements separately from the land itself.

contra revenue account

Both sales returns and sales allowances are classified as contra revenues. A contra revenue account is an account with a balance that is opposite, or "contra," to that of its related revenue account. The reason we use a contra revenue account is to keep a record of the total revenue earned separate from the reduction due to subsequent sales returns or sales allowances. Rather than analyze debits to the Service Revenue account, managers can more easily analyze debits to the Sales Returns or Sales Allowances accounts. Companies sometimes combine their sales returns and sales allowances in a single Sales Returns and Allowances account. For homework, use separate Sales Returns and Sales Allowances accounts.

CONSISTENCY IN REPORTING

Companies can choose which inventory method they prefer, even if the method does not match the actual physical flow of goods. However, once the company chooses a method, it is not allowed to frequently change to another one.1 For example, a retail store cannot use FIFO in the current year because inventory costs are rising and then switch to LIFO in the following year because inventory costs are now falling. However, a company need not use the same method for all its inventory. International Paper Company, for instance, uses LIFO for its raw materials and finished pulp and paper products, and both FIFO and weighted-average cost for other inventories. Because of the importance of inventories and the possible differential effects of different methods on the financial statements, a company informs its stockholders of the inventory method(s) being used in a note to the financial statements.

TAX DEPRECIATION

Conflicting with the desire to report higher net income is the desire to reduce taxes by reducing taxable income. An accelerated method serves this objective by reducing taxable income more in the earlier years of an asset's life than does straight-line. As a result, most companies use the straight-line method for financial reporting and the Internal Revenue Service's prescribed accelerated method (called MACRS3) for income tax purposes. Thus, companies record higher net income using straight-line depreciation and lower taxable income using MACRS depreciation. MACRS combines declining-balance methods in earlier years with straight-line in later years to allow for a more advantageous tax depreciation deduction. Congress, not accountants, approved MACRS rules to encourage greater investment in long-term assets by U.S. companies.

allowance for uncollectible accounts (also called allowance for doubtful accounts)

Contra asset account representing the amount of accounts receivable that we do not expect to collect. we adjust for future bad debts by making this the allowance account provides a way to reduce accounts receivable indirectly, rather than decreasing the accounts receivable balance itself. We report the allowance for uncollectible accounts in the asset section of the balance sheet, but it represents a reduction in the balance of accounts receivable.

-When the movie theatre pays $1,000 to advertise its show times, it records the following transaction, regardless of whether it pays with cash, a check, or a debit card. -Because credit cards allow the purchaser to delay payment for several weeks or even months, if the theatre uses a credit card to pay for the $1,000 worth of advertising, it would record the purchase as follows.

Debit Advertising Expense 1000 Credit Cash 1000 Debit Advertising Expense 1000 Credit Accounts Payable 1000

Assume Link's Dental wants Dee to pay quickly on her teeth-whitening bill and offers her terms of 2/10, n/30. This means that if Dee pays within 10 days, the amount due ($350 after the $100 trade discount and the $50 sales allowance) will be reduced by 2% (or $7 = $350 × 2%). Collection During the Discount Period.Let's see what happens when Dee pays within 10 days: Assume that Dee pays on March 10, which is within the 10-day discount period. Link's Dental records the following entry when it receives payment. Collection After the Discount Period: For our second scenario, assume that Dee waits until March 31 to pay, which is not within the 10-day discount period. Link's Dental records the following transaction at the time it collects cash from Dee.

Debit Cash 343 debit sales discounts 7 credit accounts receivable 350 Debit cash 350 credit accounts receivable 350

In May, Starlight withdraws cash of $200 from the bank to have on hand in the petty cash fund. Starlight also issues credit cards to its purchasing manager and marketing manager. At the time these cards are issued, nothing is recorded because no expenditures have been made. However, for the petty cash fund, cash has been withdrawn from the bank, so we record the following entry that formally shows the transfer of cash from the bank to cash on hand in the petty cash fund:

Debit Petty Cash (on hand) 200 Credit Cash (checking account) 200

ESTIMATING UNCOLLECTIBLE ACCOUNTS IN THE FOLLOWING YEAR At the end of 2019, Kimzey must once again estimate uncollectible accounts and make a year-end adjustment. Recall that Kimzey estimated bad debts in 2019 to be $5 million but only $4 million was actually written off. This means the balance of the allowance account at the end of 2019 prior to any year-end adjustment is $1 million. Suppose that in 2019 Kimzey bills customers for services totaling $80 million, and $30 million are still receivable at the end of the year. Of the $30 million still receivable, let's say Kimzey again uses the aging method and estimates $8 million will not be collected. For what amount would Kimzey record the year-end adjusting entry for bad debts in 2019? Before answering, let's first examine the current balance of the allowance account, as shown in Illustration 5-8. Notice that the balance before the year-end adjustment in this example is a $1 million credit. A credit balance before adjustment indicates that the estimate of uncollectible accounts at the beginning of the year (or end of last year) may have been too high. However, it's possible that some of the estimated uncollectible accounts have not proven bad yet. A debit balance before adjustment indicates that the estimate at the beginning of the year was too low. Based on all available information at the end of 2019, Kimzey estimates that the allowance for uncollectible accounts should be $8 million. This means the allowance account needs to increase from its current balance of $1 million credit to the estimated ending balance of $8 million credit. Kimzey can accomplish this by adjusting the account for $7 million as follows:

Debit bad debt expense 7 Credit allowance for uncollectible accounts 7

Acceptance of Debit Cards.

Debit cards also provide an additional control for cash receipts. Like credit cards, debit cards offer customers a way to purchase goods and services without a physical exchange of cash. They differ, however, in that most debit cards (sometimes referred to as check cards) work just like a check and withdraw funds directly from the cardholder's bank account at the time of use. (Recall that credit cards don't remove cash from the cardholder's account after each transaction.)

Another example of the use of notes receivable is to replace existing accounts receivable. For example, suppose that Justin received $10,000 of services on account, but Kimzey originally recorded the amount due as Accounts Receivable. Over time, it became apparent that Justin would not be able to pay quickly, so Kimzey required Justin to sign a six-month, 12% promissory note on February 1, 2018. When Justin signs the note, Kimzey records the following transaction to reclassify the existing account receivable as a note receivable.

Debit notes receivable 10,000 Credit Accounts Receivable 10,000 Recognize that the transaction has no impact on the accounting equation; it is simply a matter of reclassifying assets. One asset (notes receivable) increases, while another asset (accounts receivable) decreases.

Mario's ending balance of Inventory using FIFO is $2,200. Under LIFO, it is only $1,600 (see Illustration 6-7). As a result, if Mario's Game Shop wants to adjust its FIFO inventory records to LIFO for preparing financial statements, it needs to adjust Inventory downward by $600 (decreasing the balance from $2,200 to $1,600).

December 31 debit cost of goods sold 600 credit inventory 600

Calculating Interest Revenue over Time for Kimzey Medical Clinic: Because Kimzey earns two months of interest in 2018, it must accrue that interest as revenue on December 31, 2018 (even though no cash has been collected). The adjustment to accrue interest revenue follows. On May 1, 2019, the maturity date, Kimzey records the collection of the note receivable of $10,000 and interest of $600. Notice that the cash collected for interest includes $200 receivable from 2018, as well as $400 of additional interest revenue related to four months in 2019.

December 31, 2018: Debit interest receivable 200 credit interest revenue 200 interest revenue=10000 x 12% x 2/12 May 1, 2019: debit cash 10600 credit notes receivable 10000 credit interest receivable(from 2018) 200 credit interest revenue (from 2019) 400 interest revenue=10000 x 12% x 4/12 (The entry on May 1, 2019, eliminates the balances of the note receivable and interest receivable recorded in 2018.)

ASSET IMPAIRMENT

Depreciation and amortization represent a gradual consumption of the benefits inherent in property, plant, and equipment and intangible assets. Situations can arise, however, that cause a significant decline or impairment of the total benefits or service potential of specific long-term assets. For example, if a retail chain closed several stores and no longer used them in operations, the buildings and equipment may be subject to impairment. Sears Holding Corporation, the parent company of Sears and Kmart, recorded impairment charges of $220 million in a recent year related to the write-down of buildings and other fixed assets associated with a closing of selected stores. Management must review long-term assets for impairment. Impairment occurs when the expected future cash flows (expected future benefits) generated for a long-term asset fall below its book value (original cost minus accumulated depreciation).

Depreciation

Depreciation in accounting is allocating the cost of an asset to an expense over its service life. An asset provides benefits (revenues) to a company in future periods. We allocate a portion of the asset's cost to depreciation expense in each year the asset provides a benefit. If the asset will provide benefits to the company for four years, for example, then we allocate a portion of the asset's cost to depreciation expense in each year for four years. Illustration 7-8 portrays this concept of depreciating an asset's original purchase cost over the periods benefited.

Change in Depreciation Estimate.

Depreciation is an estimate. Remember that the amount of depreciation allocated to each period is based on management's estimates of service life and of residual value—as well as the depreciation method chosen. Management needs to periodically review these estimates. If a change in estimate is required, the company changes depreciation in current and future years, but not in prior periods. For example, assume that after three years Little King Sandwiches estimates the remaining service life of the delivery truck to be four more years, for a total service life of seven years rather than the original five. At this time, Little King also changes the estimated residual value to $3,000 from the original estimate of $5,000. How much should Little King record each year for depreciation in years 4 to 7? Take the book value at the end of year 3 ($19,000), subtract the new estimated residual value ($3,000), and then divide by the new remaining service life (four more years). Little King Sandwiches will record depreciation in years 4 to 7 as $4,000 per year. Illustration 7-12 shows the calculations.

The primary dictionary definition of depreciation differs from the definition of depreciation used in accounting:

Dictionary definition = Decrease in value (or selling price) of an asset. Accounting definition = Allocation of an asset's cost to an expense over time.

discount terms

Discount terms, such as 2/10, n/30, are a shorthand way to communicate the amount of the discount and the time period within which it's available. The term "2/10," pronounced "two ten," for example, indicates the customer will receive a 2% discount if the amount owed is paid within 10 days. The term "n/30," pronounced "net thirty," means that if the customer does not take the discount, full payment net of any returns or allowances is due within 30 days.

EQUIPMENT

Equipment is a broad term that includes machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures. The cost of equipment is the actual purchase price plus all other costs necessary to prepare the asset for use. These can be any of a variety of other costs including sales tax, shipping, delivery insurance, assembly, installation, testing, and even legal fees incurred to establish title. What about recurring costs related to equipment, such as annual property insurance and annual property taxes on vehicles? Rather than including recurring costs as part of the cost of the equipment, we expense them as we incur them. The question to ask yourself when deciding whether to add a cost to the asset account or record it as an expense of the current period is, "Is this a cost of acquiring the asset and getting it ready for use, or is it a recurring cost that benefits the company in the current period?" Assume that Olive Garden purchases new restaurant equipment for $82,000 plus $6,500 in sales tax. It pays a freight company $800 to transport the equipment and $200 shipping insurance. The firm pays $1,600 for one year of liability insurance on the equipment in advance. The equipment was also installed at an additional cost of $1,500. Illustration 7-3 shows the calculation of the amount at which Olive Garden should record the cost of the equipment. Thus, Olive Garden should record the equipment at a total cost of $91,000. With the exception of the $1,600 annual insurance on the equipment, each of the expenditures described was necessary to bring the equipment to its condition and location for use. Olive Garden will report the $1,600 for one year of liability insurance as prepaid insurance and allocate the $1,600 to insurance expense over the first year of coverage.

STEP 1: RECONCILE THE BANK'S CASH BALANCE

First, we consider cash transactions recorded by the company, but not yet recorded by its bank. These include deposits outstanding and checks outstanding.

amortization

For intangible assets, the cost allocation process is called amortization.

freight-in

Freight charges on incoming shipments from suppliers We add the cost of freight-in to the balance of Inventory

GOODWILL

Goodwill often is the largest (and the most unique) intangible asset in the balance sheet. It is recorded only when one company acquires another company. Goodwill is recorded by the acquiring company for the amount that the purchase price exceeds the fair value of the acquired company's identifiable net assets.

Why Choose LIFO?

If FIFO results in higher total assets and higher net income and produces amounts that most closely follow the actual flow of inventory, why would any company choose LIFO? The primary benefit of choosing LIFO is tax savings. LIFO results in the lowest amount of reported profits (when inventory costs are rising). While that might not look so good in the income statement, it's a welcome outcome in the tax return. When taxable income is lower, the company owes less in taxes to the Internal Revenue Service (IRS). LIFO generally results in greater tax savings. Can a company have its cake and eat it too by using FIFO for financial reporting and LIFO for the tax return? No. The IRS established the LIFO conformity rule, which requires a company that uses LIFO for tax reporting to also use LIFO for financial reporting.

Inventory Calculation Using the LIFO Method (example): jan 1 beginning inventory 100 units for $7 unit cost total cost 700 april 25 purchase 300 for 9 unit cost total cost 2700 october 19 purchase 600 unit cost 11 total cost 6600 total goods available for sale: 1,000 total cost: 10,000 total sales to customers: 800 ending inventory: 200

If Mario sold 800 units, we assume all the 600 units purchased on October 19 (the last purchase) were sold, along with 200 units from the April 25 purchase. That leaves 100 of the units from the April 25 purchase and all 100 units from beginning inventory assumed to remain in ending inventory (not sold). Illustration 6-7 shows calculations of cost of goods sold and ending inventory for the LIFO method. 200(number of units april 25) x 9(unit cost april 25)=$1800 600(number of units oct 19) x 11(unit cost oct 19)=$6600 cost of goods sold: $1800+$6600=$8400 ending inventory: $700+$900=$1600

restricted cash

In addition, some companies separately report restricted cash. Restricted cash represents cash that is not available for current operations. Examples of restricted cash include cash set aside by the company for specific purposes such as repaying debt, purchasing equipment, or making investments in the future.

Periodic inventory system

In contrast, a periodic inventory system does not continually record inventory amounts. Instead, it calculates the balance of inventory once per period, at the end, based on a physical count of inventory on hand. Because the periodic system does not provide a useful, continuing record of inventory, very few companies actually use the periodic inventory system in practice to record inventory transactions. Therefore, in this section, we will focus on how to record inventory transactions using the system most often used in practice—the perpetual inventory system. Appendix A to the chapter shows how to record transactions using the periodic inventory system.

Subsidiary Ledgers

In practice, all companies maintain records for individual customer accounts to help in tracking amounts receivable and in estimating amounts uncollectible. This idea was demonstrated in Illustration 5-6. A subsidiary ledger contains a group of individual accounts associated with a particular general ledger control account. For example, the subsidiary ledger for accounts receivable keeps track of all increases and decreases to individual customers' accounts. The balances of all individual accounts then sum to the balance of total accounts receivable in the general ledger and reported in the balance sheet. Subsidiary ledgers are also used for accounts payable, property and equipment, investments, and other accounts.

when would the LIFO adjustment be reversed

In rare situations where the LIFO Inventory balance is greater than the FIFO Inventory balance (such as when inventory costs are declining), the entry for the LIFO adjustment would be reversed.

Sarbanes-Oxley Act

In response to these corporate accounting scandals and to public outrage over seemingly widespread unethical behavior of top executives, Congress passed the Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly referred to as SOX. SOX applies to all companies that are required to file financial statements with the SEC and represents one of the greatest reforms in business practices in U.S. history. The act established a variety of guidelines related to auditor-client relations and internal control procedures

sales return

In some cases, customers may not be satisfied with a product or service purchased. If a customer returns a product, we call that a sales return. After a sales return, (a) we reduce the customer's account balance if the sale was on account or (b) we issue a cash refund if the sale was for cash.

Purchase Returns: For example, when Mario decides on October 22 to return 50 defective units from the 600 units purchased on October 19 for $11 each, the company would record the following transaction:

October 22 debit accounts payable 550 credit inventory 550 550=50 defective units x $11

percentage-of-credit-sales method or the income statement method

In the chapter, we estimated uncollectible accounts based on a percentage of accounts receivable at the end of the period. You learned that this method is the percentage-of-receivables method or the balance sheet method, because we base the estimate of bad debts on a balance sheet amount—accounts receivable. The estimated percentage could be a single percentage applied to the entire balance of accounts receivable, or it could vary based on the age of individual accounts receivable (the aging method). As an alternative, we can estimate uncollectible accounts based on the percentage of credit sales for the year, aptly referred to as the percentage-of-credit-sales method or the income statement method, because we base the estimate of bad debts on an income statement amount—credit sales. In this appendix, we consider the percentage-of-credit-sales method.

The calculation of goodwill is easiest to see with a simple example. Assume that Allied Foods acquires Ritz Produce by paying $36 million in cash. The fair values of Ritz Produce's identifiable assets and liabilities are as follows ($ in millions): accounts receivable 10 equipment 32 patent 8 total fair value assets 50 accounts payable 9 long term notes payable 15 total fair value of liabilities 24

In this example, Ritz Produce has identifiable net assets of $26 million (= $50 million − $24 million). Why is Allied Foods willing to pay $36 million to acquire a company that has identifiable net assets of only $26 million? Allied Foods must believe that there are other benefits worth $10 million in the acquisition, but these benefits are not identified as assets in the balance sheet of Ritz Produce. Allied Food will record these unidentified assets as goodwill at the time it pays $36 million. Illustration 7-6 summarizes the calculation of goodwill ($10 million) that Allied Foods would report in its balance sheet. business acquisition with goodwill: purchase price 36 less:fair value of assets acquired 50 less: fair value of liabilities assumed (24) fair value of identifiable net assets (26) goodwill 10 Allied Foods records the acquisition as follows: debit accounts receivable (at fair value) 10 debit equipment(at fair value) 32 debit patent (at fair value) 8 goodwill (remaining purchase price) 10 credit accounts payable (at fair value) 9 credit notes payable (at fair value) 15 credit cash(at purchase price) 36

first-in, first-out (FIFO) method

Inventory costing method that assumes the first units purchased (the first in) are the first ones sold (the first out). We assume that beginning inventory sells first, followed by the inventory from the first purchase during the year, followed by the inventory from the second purchase during the year, and so on.

Accrued Interest (using same example as above)

It frequently happens that a note is issued in one year and the maturity date occurs in the following year. For example, what if Justin Payne issued the previous six-month note to Kimzey on November 1, 2018, instead of February 1, 2018? In that case, the $10,000 face value (principal) and $600 interest on the six-month note are not due until May 1, 2019. The length of the note (six months) and interest rate (12%) remain the same, and so the total interest of $600 charged to Justin remains the same. However, Kimzey will earn interest revenue in two separate accounting periods (assuming Kimzey uses a calendar year): for two months of the six-month note in 2018 (November and December), and for four months in the next year (January through April). Illustration 5-14 demonstrates the calculation of interest revenue over time. Interest receivable from Kimzey's six-month, $10,000, 12% note is $100 per month (= $10,000 × 12% × 1/12).

-Specific identification method -used by who and why

It matches—identifies—each unit of inventory with its actual cost. For example, an automobile has a unique serial number that we can match to an invoice identifying the actual purchase price. Fine jewelry and pieces of art are other possibilities. Specific identification works well in such cases. However, the specific identification method is practicable only for companies selling unique, expensive products. Consider the inventory at The Home Depot or Macy's: large stores and numerous items, many of which are relatively inexpensive. Specific identification would be very difficult for such merchandisers. Although bar codes and RFID tags now make it possible to identify and track each unit of inventory, the costs of doing so outweigh the benefits for multiple, small inventory items. For that reason, the specific identification method is used primarily by companies with unique, expensive products with low sales volume.

On July 17, Mario sold 300 units of inventory on account for $15 each, resulting in total sales of $4,500. We make two entries to record the sale: (1) The first entry shows an increase to the asset account (in this case, Accounts Receivable) and an increase to Sales Revenue. 2) The second entry reduces the Inventory account as it records cost of goods sold. Mario records as revenue the $4,500 from the July 17 sale. That amount is the price Mario charges to customers, but what did that inventory cost Mario? (That is, what is the cost of the goods sold?) Because Mario's Game Shop, like nearly all companies, actually sells its oldest inventory first (FIFO), the cost of the first 300 units purchased is $2,500, which is $700 of beginning inventory (100 units × $7) plus $1,800 of the April 25 purchase (200 units × $9). We record this amount as the cost of goods sold for the July 17 sale. At the same time, we maintain a continual (perpetual) record of inventory by reducing the Inventory balance by the cost of the amount sold, $2,500, as shown below.

July 17 debit accounts receivable 4500 credit sales revenue 4500 debit cost of inventory sold 2500 credit inventory 2500 By recording the sales revenue and the cost of goods sold at the same time, we can see that Mario's profit on the sale is $2,000.

PERCENTAGE-OF-CREDIT-SALES METHOD example

Let's rework the example in the chapter for Kimzey Medical Clinic (see Illustrations 5-8 to Illustrations 5-10 and their discussion). During 2019, Kimzey bills customers $80 million for services, with $30 million in accounts receivable remaining at the end of the year. The balance of the allowance account, before adjustment, is a $1 million credit. For the percentage-of-receivables method, we'll use the estimate for uncollectible accounts used in the chapter—$8 million based on the age of accounts receivable. For the percentage-of-credit-sales method, let's assume Kimzey expects 12.5% of credit sales to be uncollectible. Kimzey bases the 12.5% estimate on a number of factors, including current economic conditions and the average percentage of uncollectibles in the previous year, its first year of operations. Illustration 5-16 demonstrates the differences in the two methods when adjusting for estimates of uncollectible accounts. Notice that the two methods for estimating uncollectible accounts result in different adjustments. Because the amounts of the adjustments differ, the effects on the financial statements differ. Recall that the balance of the allowance account before adjustment is a $1 million credit. After adjustment, the balance of the allowance account will differ between the two methods, as will the amount of bad debt expense. Illustration 5-17 summarizes the differences in financial statement effects. From an income statement perspective, some argue that the percentage-of-credit-sales method provides a better method for estimating bad debts because expenses (bad debts) are better matched with revenues (credit sales). A better matching of expenses and revenues results in a more accurate measure of net income for the period. From a balance sheet perspective, though, the percentage-of-receivables method is preferable because assets (net accounts receivable) are reported closer to their net realizable value. The current emphasis on better measurement of assets (balance sheet focus) outweighs the emphasis on better measurement of net income (income statement focus). This is why the percentage-of-receivables method (balance sheet method) is the preferable method, while the percentage-of-credit-sales method (income statement method) is allowed only if amounts do not differ significantly from estimates using the percentage-of-receivables method.

CONTROLS OVER CASH DISBURSEMENTS

Managers should design proper controls for cash disbursements to prevent any unauthorized payments and ensure proper recording. Consistent with our discussion of cash receipts, cash disbursements include not only disbursing physical cash, but also writing checks and using credit cards and debit cards to make payments. All these forms of payment constitute cash disbursement and require formal internal control procedures

NATURAL RESOURCES

Many companies depend heavily on natural resources, such as oil, natural gas, timber, and even salt. ExxonMobil, for example, maintains oil and natural gas deposits on six of the world's seven continents. Weyerhaeuser is one of the largest pulp and paper companies in the world with major investments in timber forests. Even salt is a natural resource, with the largest supply in the United States mined under the Great Lakes of North America. We can distinguish natural resources from other property, plant, and equipment by the fact that we can physically use up, or deplete, natural resources. ExxonMobil's oil reserves are a natural resource that decreases as the firm extracts oil. Similarly, timber land is used up to produce materials in the construction industry and salt is extracted from salt mines for use in cooking and melting icy roads.

materiality

Materiality relates to the size of an item that is likely to influence a decision. An item is said to be material if it is large enough to influence a decision. Materiality is an important consideration in the "capitalize versus expense" decision. There often are practical problems in capitalizing small expenditures. For example, a stapler may have a 20-year service life, but it would not be practical to capitalize such a small amount. Companies generally expense all costs under a certain dollar amount, say $1,000, regardless of whether future benefits are increased. It's important for a company to establish a policy for treating these expenditures and apply the policy consistently.

percentage-of-receivables method

Method of estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected. also referred to as the balance sheet method

CONTROLS OVER CASH RECEIPTS

Most businesses receive payment from the sale of products and services either in the form of cash or as a check received immediately or through the mail. Common controls over cash receipts include: 1.Open mail each day, and make a list of checks received, including the amount and payer's name. 2.Designate an employee to deposit cash and checks into the company's bank account each day, different from the person who receives cash and checks. 3.Have another employee record cash receipts in the accounting records as soon as possible. Verify cash receipts by comparing the bank deposit slip with the accounting records. 4.Accept credit cards or debit cards, to limit the amount of cash employees handle.

Why Choose FIFO?

Most companies' actual physical flow follows FIFO. Think about a supermarket, sporting goods store, clothing shop, electronics store, or just about any company you're familiar with. These companies generally sell their oldest inventory first (first-in, first-out). If a company wants to choose an inventory method that most closely approximates its actual physical flow of inventory, then for most companies FIFO makes the most sense. Another reason managers may want to use FIFO relates to its effect on the financial statements. During periods of rising costs, which is the case for most companies (including our example for Mario's Game Shop), FIFO results in a (1) higher ending inventory, (2) lower cost of goods sold, and (3) higher reported profit than does LIFO. Managers may want to report higher assets and profitability to increase their bonus compensation, decrease unemployment risk, satisfy shareholders, meet lending agreements, or increase stock price. FIFO matches physical flow for most companies. FIFO generally results in higher assets and higher net income when inventory costs are rising.

Net income

Next, a company subtracts income tax expense to find its bottom-line net income. Income tax expense is reported separately because it represents a significant expense. It's also the case that most major corporations (formally referred to as C corporations) are tax-paying entities, while income taxes of sole proprietorships and partnerships are paid at the individual owner level. By separately reporting income tax expense, the income statement clearly labels the difference in profitability associated with the income taxes of a corporation. Best Buy's income tax expense equals 10.2% of income before taxes (= $141 ÷ $1,387). The actual corporate tax rate for Best Buy's level of income is 35%. The reason Best Buy's income tax expense is only 10.2% is because companies sometimes operate in foreign jurisdictions with lower tax rates or because tax rules differ from financial reporting rules. Differences in reporting rules can result in financial income differing from taxable income in any particular year. A more realistic tax expense for Best Buy can be calculated by looking at amounts over the three-year period ending January 31, 2015. Best Buy's cumulative tax expense divided by cumulative income before income taxes for 2013, 2014, and 2015 equaled 32.0%.

Why is the direct write off method of accounting for uncollectible accounts not permitted for financial reporting purposes except in limited circumstances

Notice that bad debt expense is recorded in the year of the write-off (2019) instead of the year of the service revenue (2018). Total assets are also reduced by crediting Accounts Receivable at the time of the actual write-off (2019). Compared to the allowance method, the direct write-off method causes assets to be overstated and operating expenses to be understated in 2018.

Purchase Returns

Occasionally, a company will find inventory items to be unacceptable for some reason—perhaps they are damaged or are different from what was ordered. In those cases, the company returns the items to the supplier and records the purchase return as a reduction in both Inventory and Accounts Payable.

lower of cost and net realizable value

Once a company has determined both the cost and the net realizable value of inventory, it reports ending inventory in the balance sheet at the lower of the two amounts. This method of recording inventory is lower of cost and net realizable value method where companies report inventory in the balance sheet at the lower of cost and net realizable value, where net realizable value equals estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation.

Expenditures after Acquisition

Over the life of a long-term asset, the owners often incur additional expenditures for repairs and maintenance, additions, improvements, or litigation costs. We credit these costs to Cash or perhaps to Accounts Payable or Notes Payable, but what account do we debit? The choice is to debit either an asset or an expense. Recall that an asset is a probable future benefit. We capitalize an expenditure as an asset if it increases future benefits. We expense an expenditure if it benefits only the current period. To see the choice more clearly, let's look at repairs and maintenance, additions, improvements, and litigation costs in more detail.

What is the effect in Kimzey's financial statements when writing off Bruce's account receivable?

Overall, the write-off of the account receivable has no effect on total amounts reported in the balance sheet or in the income statement. Notice that there is no decrease in total assets and no decrease in net income with the write-off. Here's why: We have already recorded the negative effects of the bad news. Kimzey recorded those effects when it estimated future bad debts at the end of 2018 by recording a debit to bad debt expense and a credit to the allowance account. So, when Bruce declares bankruptcy in the following year, 2019, we had already established the allowance for this bad debt. The write-off on February 23, 2019, reduces both an asset account (Accounts Receivable) and its contra asset account (Allowance for Uncollectible Accounts), leaving the net receivable unaffected. Thus, the entry to record the actual write-off results in no change to total assets and no change to net income.

perpetual inventory system

Recall that under a perpetual inventory system we maintain a continual—or perpetual—record of inventory purchased and sold

allowance method

Recording an adjustment at the end of each period to allow for the possibility of future uncollectible accounts. The adjustment has the effects of reducing assets and increasing expenses. Generally Accepted Accounting Principles (GAAP) require that we account for uncollectible accounts using what's called the allowance method. This method involves allowing for the possibility that some accounts will be uncollectible at some point in the future.3 Be sure to understand this key point. Using the allowance method, we account for events (customers' bad debts) that have not yet occurred but that are likely to occur. This is different from other transactions you've learned about to this point. Those earlier transactions involved recording events that have already occurred, such as purchasing supplies, paying employees, and providing services to customers. Under the allowance method, companies are required to estimate future uncollectible accounts and record those estimates in the current year. An account receivable we do not expect to collect has no value. Thus, we need to (1) reduce assets (accounts receivable) by an estimate of the amount we don't expect to collect. At the same time, failure to collect a customer's cash represents a cost inherent in using credit sales, so we also need to (2) increase expenses (bad debt expense) to reflect the cost of offering credit to customers. The bad debt expense will decrease net income. In the next section, we'll see how to use the allowance method to record estimated bad debts.

service life

Recording depreciation requires accountants to estimate the service life of the asset, as well as its residual value at the end of that life. The service life, or useful life, is how long the company expects to receive benefits from the asset before disposing of it. We can measure service life in units of time or in units of activity. For example, the estimated service life of a delivery truck might be either five years or 100,000 miles. We use the terms service life and useful life interchangeably, because both terms are used in practice. Common Terms Service life often is called useful life.

Reporting intangible assets that are developed internally

Reporting intangible assets that are developed internally is quite different. Rather than reporting these in the balance sheet as intangible assets, we expense in the income statement most of the costs for internally developed intangible assets in the period we incur those costs. For example, the research and development (R&D) costs incurred in developing a patent internally are not recorded as an intangible asset in the balance sheet. Instead, they are expensed directly in the income statement. The reason we expense all R&D costs is the difficulty in determining the portion of R&D that benefits future periods. Conceptually, we should record as an intangible asset the portion that benefits future periods. Due to the difficulties in arriving at this estimate, current U.S. accounting rules require firms to expense all R&D costs as incurred. A similar argument about the difficulty of estimating benefits in future periods can be made for advertising expenses. Advertising at Apple clearly has made its trademark more valuable. Because we cannot tell what portion of today's advertising benefits future periods and how many periods it might benefit, advertising costs are not reported as an intangible asset in the balance sheet. Instead, advertising costs are recorded as expenses and are reported in the income statement in the period incurred.

sales allowance

Seller reduces the customer's balance owed or provides at least a partial refund because of some deficiency in the company's product or service.

Sale of Long-Term Assets

Selling a long-term asset can result in either a gain or a loss. We record a gain if we sell the asset for more than its book value. Similarly, we record a loss if we sell the asset for less than its book value. A gain is a credit balance account like other revenue accounts; a loss is a debit balance account like other expense accounts. Gains and losses, along with items such as interest revenue and interest expense, are recorded on the income statement as nonoperating revenues and expenses. Remember, book value is the cost of the asset minus accumulated depreciation. In order to have the correct book value, it's important to record depreciation up to the date of the sale.

BASKET PURCHASES

Sometimes companies purchase more than one asset at the same time for one purchase price. This is known as a basket purchase. For example, assume Olive Garden purchases land, building, and equipment together for $900,000. We need to record land, building, and equipment in separate accounts. How much should we record in the separate accounts for land, building, and equipment? The simple answer is that we allocate the total purchase price of $900,000 based on the estimated fair values of each of the individual assets. Estimated fair values are estimates of what the separate assets are worth. The difficulty, though, is that the estimated fair values of the individual assets often exceed the total purchase price, in this case, $900,000. Let's say the estimated fair values of land, building, and equipment are $200,000, $700,000, and $100,000, respectively, for a total estimated fair value of $1 million. In that case, Olive Garden's total purchase of $900,000 will be allocated to the separate accounts for Land, Building, and Equipment based on their relative fair values as shown in Illustration 7-4.

activity-based method,

Straight-line and declining-balance methods measure depreciation based on time. In an activity-based method, we instead allocate an asset's cost based on its use. For example, we could measure the service life of a machine in terms of its output (units, pounds, barrels). This method also works for vehicles such as our delivery truck, whose use we measure in miles. Common Terms Activity-based depreciation is also called units of production or units of output. We first compute the average depreciation rate per unit by dividing the depreciable cost (cost minus residual value) by the number of units expected to be produced. In our illustration, the depreciation rate is $0.35 per mile, calculated as shown in Illustration 7-14. ILLUSTRATION 7-14 Formula for Activity-Based Depreciation depreciation rate per unit= depreciable cost/total units expected to be produced To calculate the depreciation expense for the reporting period, we then multiply the per unit rate by the number of units of activity each period. Illustration 7-15 shows a depreciation schedule using the activity-based method. The actual miles driven in years 1 to 5 were 30,000, 22,000, 15,000, 20,000, and 13,000. Notice that the activity-based method is very similar to the straight-line method, except that rather than dividing the depreciable cost by the service life in years, we divide it by the service life in expected miles.

accelerated depreciation method

Straight-line depreciation assumes that the benefits we derive from the use of an asset are the same each year. In some situations it might be more reasonable to assume that the asset will provide greater benefits in the earlier years of its life than in the later years. In these cases, we achieve a better matching of depreciation with revenues by using an accelerated depreciation method, with higher depreciation in the earlier years of the asset's life and lower depreciation in later years. We look at one such method next.

FRANCHISES

Subway, McDonald's, and KFC are three of the world's largest franchises. Many popular retail businesses such as restaurants, auto dealerships, and hotels are set up as franchises. These are local outlets that pay for the exclusive right to use the franchisor company's name and to sell its products within a specified geographical area. Many franchisors provide other benefits to the franchisee, such as participating in the construction of the retail outlet, training employees, and purchasing national advertising. To record the cost of a franchise, the franchisee records the initial fee as an intangible asset. Additional periodic payments to the franchisor usually are for services the franchisor provides on a continuing basis, and the franchisee will expense them as incurred.

land

The Land account represents land a company is using in its operations. (In contrast, land purchased for investment purposes is recorded in a separate investment account.) We capitalize to Land all expenditures necessary to get the land ready for its intended use. Such capitalized costs include the purchase price of the land plus closing costs such as fees for the attorney, real estate agent commissions, title, title search, and recording fees. If the property is subject to back taxes or other obligations, we include these amounts as well. In fact, any additional expenditure such as clearing, filling, and leveling the land, or even removing existing buildings to prepare the land for its intended use, become part of the land's capitalized cost. If we receive any cash from selling salvaged building materials, we reduce the cost of land by that amount. Assume, for instance, that Olive Garden, a restaurant chain owned by Darden Restaurants purchases a two-acre tract of land and an existing building for $500,000. The company plans to remove the existing building and construct a new Olive Garden restaurant on the site. In addition to the purchase price, the company pays a sales commission of $30,000 to the real estate agent and title insurance of $3,000. Olive Garden also pays $8,000 in property taxes, which includes $6,000 of back taxes (unpaid taxes from previous years) paid by Olive Garden on behalf of the seller and $2,000 due for the current fiscal year after the purchase date. Shortly after closing, the company pays a contractor $50,000 to tear down the old building and remove it from the site. Olive Garden is able to sell salvaged materials from the building for $5,000 and pays an additional $6,000 to level the land. Using the guideline of cost plus all expenditures necessary to get the asset ready for use, at what amount should Olive Garden record as the total cost of the land? Illustration 7-2 provides the details in computing the cost of the land. You may wonder why Olive Garden recorded only $6,000 for property taxes. That was the amount required to get the asset ready for use—Olive Garden could not use the land until it paid the back taxes. The additional $2,000 in property taxes, though, relates only to the current period, so Olive Garden records that amount as an expense in the current period. All of the other costs, including the $6,000 in back property taxes, are necessary to acquire the land, so Olive Garden capitalizes them. Note that the salvaged materials sold for $5,000 reduce the overall cost of the land.

Acceptance of Credit Cards. For example, suppose a movie theatre accepts MasterCard as payment for $2,000 worth of movie tickets, and MasterCard charges the movie theatre a service fee of 3% (or $60 on sales of $2,000). Moviegoers don't pay cash to the theatre at the time of sale, but MasterCard deposits cash, less the service fee expense, into the theatre's account usually within 24 hours.

The acceptance of credit cards provides an additional control by reducing employees' need to directly handle cash. The term credit card is derived from the fact that the issuer, such as Visa® or MasterCard®, extends credit (lends money) to the cardholder each time the cardholder uses the card. Meanwhile, the credit card company deposits cash in the company's bank for the amount of the sale, less service fees. Credit card companies earn revenues primarily in two ways. First, the cardholder has a specified grace period before he or she has to pay the credit card balance in full. If the balance is not paid by the end of the grace period, the issuing company will charge a fee (interest). Second, credit card companies charge the retailer, not the customer, for the use of the credit card. This charge generally ranges from 2% to 4% of the amount of the sale. Therefore, the theatre records the $2,000 credit card transaction as $1,940 cash received and $60 service fee expense. Journal: Debit Cash 1,940 Debit Service Fee Expense 60 Credit Service Revenue 2,000

bad debt expense

The amount of the adjustment to the allowance for uncollectible accounts, representing the cost of estimated future bad debts charged to the current period.

cash equivalents

The balance of cash also includes cash equivalents, which are defined as short-term investments that have a maturity date no longer than three months from the date of purchase. Common examples of such investments are money market funds, Treasury bills, and certificates of deposit.

repairs and maintenance

The cost of an engine tune-up or the repair of an engine part for a delivery truck allows the truck to continue its productive activity. We expense repairs and maintenance expenditures like these in the period incurred because they maintain a given level of benefits. We capitalize as assets more extensive repairs that increase the future benefits of the delivery truck, such as a new transmission or an engine overhaul.

freight-out

The cost of freight on shipments to customers Shipping charges for outgoing inventory are reported in the income statement either as part of cost of goods sold or as an operating expense, usually among selling expenses. If a company adopts a policy of not including shipping charges in cost of goods sold, both the amounts incurred during the period as well as the income statement classification of the expense must be disclosed

Accumulated Depreciation

The credit side of the entry requires some explanation. Accumulated Depreciation is a contra asset account, meaning that it reduces an asset account. Rather than credit the Equipment account directly, we instead credit its contra account, which we offset against the Equipment account in the balance sheet. In this manner, a company can keep track of the amount originally paid for the equipment and the amount of depreciation taken on the asset so far. Most companies have separate accumulated depreciation accounts for each specific asset or asset class. For simplicity, we use one general account called Accumulated Depreciation. The name of the account comes from the fact that the depreciation we record each period accumulates in the account. After one year, for instance, we have:

declining-balance method

The declining-balance method is an accelerated depreciation method. Declining-balance depreciation will be higher than straight-line depreciation in earlier years, but lower in later years. However, both declining-balance and straight-line will result in the same total depreciation over the asset's service life. No matter what allocation method we use, total depreciation over the asset's service life will be equal to the depreciable cost (asset cost minus residual value). The depreciation rate we use under the declining-balance method is a multiple of the straight-line rate, such as 125%, 150%, or 200% of the straight-line rate. The most common declining-balance rate is 200%, which we refer to as the double-declining-balance method since the rate is double the straight-line rate. In our illustration for Little King Sandwiches, the double-declining-balance rate would be 40% (double the straight-line rate of 20%). Illustration 7-13 provides a depreciation schedule using the double-declining-balance method. The declining-balance method is an accelerated depreciation method. Declining-balance depreciation will be higher than straight-line depreciation in earlier years, but lower in later years. However, both declining-balance and straight-line will result in the same total depreciation over the asset's service life. No matter what allocation method we use, total depreciation over the asset's service life will be equal to the depreciable cost (asset cost minus residual value). The depreciation rate we use under the declining-balance method is a multiple of the straight-line rate, such as 125%, 150%, or 200% of the straight-line rate. The most common declining-balance rate is 200%, which we refer to as the double-declining-balance method since the rate is double the straight-line rate. In our illustration for Little King Sandwiches, the double-declining-balance rate would be 40% (double the straight-line rate of 20%). Illustration 7-13 provides a depreciation schedule using the double-declining-balance method.

residual value,

The depreciation process also requires accountants to estimate what an asset's value will be at the end of its service life. Called residual value, or salvage value, this value is the amount the company expects to receive from selling the asset at the end of its service life. A company might estimate residual value from prior experience or by researching the resale values of similar types of assets. Due to the difficulty in estimating residual value, it's not uncommon to assume a residual value of zero. Common Terms Residual value often is called salvage value Remember: We record depreciation for land improvements, buildings, and equipment, but we don't record depreciation for land. Unlike other long-term assets, land is not "used up" over time.

net accounts receivable or net realizable value

The difference between total accounts receivable and the allowance for uncollectible accounts.

LIFO reserve

The difference in reported inventory when using LIFO instead of FIFO is commonly referred to as the LIFO reserve.

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUES

The discussion above deals with how companies record contra revenues—sales discounts, sales returns, and sales allowances—during the year. However, companies also must adjust for these amounts at the end of the year using adjusting entries. The revenue recognition standard (ASU No. 2014-09) issued in 2014 requires a company to report revenues equal to the amount of cash the company "expects to be entitled to receive." Those expectations could change as new information becomes available.1

legal defense of intangible assets

The expenditures after acquisition mentioned so far—repairs and maintenance, additions, and improvements—generally relate to property, plant, and equipment. Intangible assets, though, also can require expenditures after their acquisition, the most frequent being the cost of legally defending the right that gives the asset its value. For example, when The J.M. Smucker Company attempted to prevent another company from copying its peanut butter and jelly sandwich patent, it incurred legal costs. If a firm successfully defends an intangible right, it should capitalize the litigation costs. However, if the defense of an intangible right is unsuccessful, then the firm should expense the litigation costs as incurred because they provide no future benefit.

Intangible Assets

The other major category of long-term assets, intangible assets, have no physical substance. Assets in this category include patents, trademarks, copyrights, franchises, and goodwill. Page 328 Despite their lack of physical substance, intangible assets can be very valuable indeed. One of the most valuable intangible assets for many companies is their trademark or brand. Interbrand publishes an annual list of the 100 most valuable brands. Illustration 7-5 summarizes the top 10 most valuable brands. As you can see, the Apple brand has an estimated value of $118.9 billion. Despite this value, Apple reports total intangible assets on its balance sheet at less than $10 billion. Later, we'll see why many intangible assets are not recorded in the balance sheet at their estimated values.

The periodic system and perpetual system will always produce

The periodic system and perpetual system will always produce the same amounts for cost of goods sold (and therefore also ending inventory) when the FIFO inventory method is used. However, when using LIFO or weighted-average, the amounts for cost of goods sold may differ between the periodic system and perpetual system. The reason for this difference is discussed further in more advanced accounting courses; it happens because determining which units of inventory are assumed sold occurs at the time of each sale throughout the period using a perpetual system but just once at the end of the period using a periodic system. For those interested, the book's online resources include additional discussion and problems related to FIFO, LIFO, and weighted--average using the perpetual inventory system. As discussed in Part B of the chapter, most companies maintain their own records on a FIFO basis and then adjust for the LIFO or weighted-average difference in preparing financial statements. The inventory recording and reporting procedures discussed in Part B of the chapter most closely reflect those used in actual practice.

how we report purchased intangible assets

The reporting rules for intangible assets vary depending on whether the company purchased the asset or developed it internally. Reporting purchased intangibles is similar to reporting purchased property, plant, and equipment. We record purchased intangible assets at their original cost plus all other costs, such as legal fees, necessary to get the asset ready for use.

END-OF-PERIOD ADJUSTMENT FOR CONTRA REVENUES We can see how this works with a simple example. Suppose General Health sells medical parts and consultation services of $400,000 on account during 2018. Also during 2018, some customers receive sales discounts totaling $6,000 for quick payment, while others return unused parts of $10,000 and others receive allowances of $14,000.

These contra revenue transactions reduce the amount of cash to be received from customers, so at the time they occur we need to reduce revenues. To reduce revenues, we debit Sales Discounts for $6,000, Sales Returns for $10,000, and Sales Allowances for $14,000. The procedure for recording these amounts was discussed earlier. In addition, at the end of 2018 the company must estimate any additional discounts, returns, and allowances that will occur in 2019 as a result of sales transactions in 2018. The reason is that some activities associated with sales transactions in 2018 will not occur until 2019 but will affect the final amount of cash received from customers. Continuing our example, suppose the company estimates an additional $1,000 in sales discounts, $2,000 in sales returns, and $3,000 in sales allowances in 2019 associated with sales in 2018. These estimates represent the expectation of less cash to be received, so according to the revenue recognition standard, we need to reduce revenue in 2018 for their amounts as well

average days in inventory

This ratio indicates the approximate number of days the average inventory is held. It is calculated as 365 days divided by the inventory turnover ratio. 365/inventory turnover ratio

Timing differences in cash occur when

Timing differences in cash occur when the company records transactions either before or after the bank records the same transactions. For example, when a movie theatre pays its popcorn supplier $2,000 by check, the company records a decrease in cash immediately, but the bank doesn't record a decrease in cash until the popcorn supplier later deposits the check. If the supplier waits a week before depositing the check, the balance of cash in the company's records will be reduced one week earlier than will the bank's. Other times, it's the bank that is the first to record a transaction. For example, banks may charge service fees for a variety of items. These fees immediately reduce the bank's record of the company's balance for cash. However, the company may not be immediately aware of these fees. Only when inspecting the bank statement will the company become aware of the cash reduction. In this case, the bank's balance for cash reflects a cash transaction before the company's balance can reflect the same transaction.

Two-Step Impairment Process

To illustrate asset impairment, suppose Little King pays $60,000 for the trademark rights to a line of specialty sandwiches. After several years, the book value is now $50,000, based on the initial cost of $60,000 less $10,000 in accumulated amortization. Unfortunately, sales for this line of specialty sandwiches are disappointing, and management estimates the total future cash flows from sales will be only $20,000. Due to the disappointing sales, the estimated fair value of the trademark is now only about $12,000. Here's how Little King determines and records the impairment loss. STEP 1: TEST FOR IMPAIRMENT The long-term asset is impaired since future cash flows ($20,000) are less than book value ($50,000). STEP 2: IF IMPAIRED, RECORD THE LOSS The loss is $38,000, calculated as the amount by which book value ($50,000) exceeds fair value ($12,000). We record the impairment loss as follows: debit loss 38000 credit trademarks 38000

perpetual inventory system

To maintain a record of inventory transactions, in practice nearly all companies use a perpetual inventory system. This system involves recording inventory purchases and sales on a perpetual (continual) basis. Managers know that to make good decisions they need to keep track each day of which inventory is selling and which is not. This information will affect decisions related to purchase orders, pricing, product development, and employee management. Because these decisions need to be made on a daily basis, maintaining inventory records on a continual basis is necessary.

allowance method vs direct-write-off method

Under the allowance method, future bad debts are estimated and recorded as an expense and a reduction in assets in 2018. Bad debt expense is recorded in the same period (2018) as the revenue it helps to create (also in 2018). Under the direct write-off method, though, we make no attempt to estimate future bad debts. We record bad debt expense in the period the account proves uncollectible. In this case, we report the bad debt expense and reduction in assets in 2019. The direct write-off method violates GAAP, since sales are recorded in one period (2018) and the related bad debt expense is recorded in the following period (2019). Notice that, either way, the ultimate effect is a $2,000 debit to Bad Debt Expense and a $2,000 credit to Accounts Receivable. The balance of Allowance for Uncollectible Accounts cancels out; it initially increases with a credit for the estimate of bad debts and then decreases with a debit for actual bad debts. The difference between the two methods is in the timing. The direct write-off method reduces accounts receivable and records bad debt expense at the time the account receivable proves uncollectible. If the credit sale occurs in a prior reporting period, bad debt expense is not properly matched with revenues (credit sales). Also, accounts receivable will be overstated in the prior period. The direct write-off method typically is not acceptable for financial reporting.

In addition to purchases and sales of inventory, we also looked at additional inventory transactions for Mario's Game Shop that related to freight charges, purchase discounts, and purchase returns: 1.On April 25, Mario pays freight charges of $300 for inventory purchased on April 25. 2.On April 30, Mario pays for the units purchased on April 25, less a 2% purchase discount. 3.On October 22, Mario returns 50 defective units from the October 19 purchase. Next, let's also compare the perpetual system and periodic system for these transactions. Freight charges

Under the perpetual system discussed in the chapter, we saw that freight charges are included as an additional cost of inventory. Here we'll see that under the periodic system, we record these charges in a separate account called Freight-in. That account will later be closed in a period-end adjustment. For freight charges of $300 associated with the April 25 purchase, we record the following transaction. perpetual system debit inventory 300 credit cash 300 periodic system debit freight-in 300 credit cash 300

1.On April 25, Mario pays freight charges of $300 for inventory purchased on April 25. 2.On April 30, Mario pays for the units purchased on April 25, less a 2% purchase discount. 3.On October 22, Mario returns 50 defective units from the October 19 purchase. PURCHASE DISCOUNTS AND RETURNS

Under the perpetual system, purchase discounts and purchase returns are recorded as a reduction in inventory cost. Under the periodic system, these transactions are recorded in separate accounts—Purchase Discounts and Purchase Returns. In the perpetual system, we credit purchase returns and purchase discounts to Inventory. The Purchase Returns and Purchase Discounts accounts used in the periodic system are referred to as contra purchases accounts. For our examples in the chapter, Mario (1) makes payment on April 30 for inventory purchased on April 25 for $2,700, receiving a $54 discount and (2) returns 50 defective units on October 22 from the 600 units purchased on account on October 19 for $11 each. perpetual system debit accounts payable 2700 credit inventory 54 credit cash 2646 periodic system debit accounts payable 2700 credit purchase discounts 54 credit cash 2646 perpetual system debit accounts payable 550 credit inventory 550 periodic system debit accounts payable 550 credit purchase returns 550

last-in, first-out (LIFO) method

Using the last-in, first-out (LIFO) method, we assume that the last units purchased (the last in) are the first ones sold (the first out).

weighted-average cost method

Using the weighted-average cost method, we assume that both cost of goods sold and ending inventory consist of a random mixture of all the goods available for sale. We assume each unit of inventory has a cost equal to the weighted-average unit cost of all inventory items. We calculate that cost at the end of the year as: weighted-average unit cost= cost of goods available for sale/number of units available for sale

RETURN ON ASSETS

Walmart had net income of $16.4 billion and Costco had net income of $2.1 billion. Since Walmart's net income is so much larger, is Walmart more profitable? Not necessarily. Walmart is also a much larger company as indicated by total assets. Walmart's total assets were $203.7 billion compared to $33.0 billion for Costco. A more comparable measure of profitability than income is return on assets, or ROA for short, which equals net income divided by average total assets. net income/average total assets The average is calculated as the beginning amount plus the ending amount, divided by 2. Dividing net income by average total assets adjusts net income for differences in company size.

Partial-Year Depreciation

We assume Little King Sandwiches bought the delivery truck at the beginning of year 1. What if it bought the truck sometime during the year instead? Then, the company will record depreciation for only the portion of the first year that it owned the truck. For example, if Little King bought the truck on November 1 and its year-end is December 31, it will record depreciation for only two of the 12 months in year 1. So, depreciation expense in year 1 is $1,167 (= $7,000 × 2/12). If instead Little King bought the truck earlier, on March 1, it will record depreciation for 10 of the 12 months in year 1. In that case, depreciation expense in year 1 is $5,833 (= $7,000 × 10/12). In both cases, depreciation for the second, third, fourth, and fifth years still is $7,000. The partial-year depreciation for the first year does not affect depreciation in those subsequent years. However, it does affect depreciation in the asset's final year of service life: Since the firm didn't take a full year of depreciation in year 1, it needs to record a partial year of depreciation in year 6 in order to fully depreciate the truck from its cost of $40,000 down to its residual value of $5,000. Depreciation in year 6 is $5,833 for the truck purchased on November 1 (= $7,000 − $1,167). If the truck was purchased on March 1, depreciation in year 6 is $1,167 (= $7,000 − $5,833).

Inventory Calculation Using the FIFO Method (example): jan 1 beginning inventory 100 units for $7 unit cost total cost 700 april 25 purchase 300 for 9 unit cost total cost 2700 october 19 purchase 600 unit cost 11 total cost 6600 total goods available for sale: 1,000 total cost: 10,000 total sales to customers: 800 ending inventory: 200 Find cost of goods sold and ending inventory

We assume that all units from beginning inventory (100 units) and the April 25 purchase (300 units) were sold. For the final 400 units sold, we split the October 19 purchase of 600 units into two groups—400 units assumed sold and 200 units assumed not sold. We calculate cost of goods sold as the units of inventory assumed sold times their respective unit costs. [That is: (100 × $7) + (300 × $9) + (400 × $11) in our example.] Similarly, ending inventory equals the units assumed not sold times their respective unit costs (200 × $11 in our example). The amount of cost of goods sold Mario reports in the income statement will be $7,800. The amount of ending inventory in the balance sheet will be $2,200. Page 273 You may have noticed that we don't actually need to directly calculate both cost of goods sold and inventory. Once we calculate one, the other is apparent. Because the two amounts always add up to the cost of goods available for sale ($10,000 in our example), knowing either amount allows us to subtract to find the other. Realize, too, that the amounts reported for ending inventory and cost of goods sold do not represent the actual cost of inventory sold and not sold. That's okay. Companies are allowed to report inventory costs by assuming which units of inventory are sold and not sold, even if this does not match the actual flow. This is another example of using estimates in financial accounting.

INTANGIBLE ASSETS NOT SUBJECT TO AMORTIZATION

We don't depreciate land because it has an unlimited life. Similarly, we do not amortize intangible assets with indefinite (unknown or not determinable) useful lives. Illustration 7-19 provides a summary of intangible assets that are amortized and those that are not amortized. An asset's useful life is indefinite if there is no foreseeable limit on the period of time over which we expect it to contribute to the cash flows of the entity. For example, suppose Little King acquired a trademark for its name. Registered trademarks have a legal life of 10 years, but the trademark registration is renewable for an indefinite number of 10-year periods. We consider the life of Little King's trademark for its name to be indefinite, so we don't amortize it.

The general rule for recording all such long-term assets can be simply stated as:

We record a long-term asset at its cost plus all expenditures necessary to get the asset ready for use. Thus, the initial cost of a long-term asset might be more than just its purchase price; it also will include any additional amounts the firm paid to bring the asset to its desired condition and location for use.

GAIN ON SALE original cost of the truck $40,000 estimated residual value $5000 estimate service life 5 years If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. The gain is equal to the sale amount of $22,000 less the truck's book value of $19,000. Illustration 7-22 shows the calculation.

We record the sale by removing the delivery truck (Equipment) and its accumulated depreciation from the accounting records and recording the cash collected. The gain is the difference between the sale amount and the book value of the asset. debit cash 22000 debit accumulated depreciation 21000 credit equipment 40000 credit gain 3000

capitalize

We use the term capitalize to describe recording an expenditure as an asset.

depreciation

We use the term depreciation to describe that process when it applies to property, plant, and equipment.

Direct write off method

We've just seen how the allowance method for uncollectible accounts works. This is the method required for financial reporting by Generally Accepted Accounting Principles (GAAP). However, for tax reporting, companies use an alternative method commonly referred to as the direct write-off method. Under the the direct write-off method, we write off bad debts only at the time they actually become uncollectible, unlike the allowance method which requires estimation of uncollectible accounts before they even occur.

Purchase Discounts: Let's assume that Mario's supplier, Luigi Software, Inc., offers terms 2/10, n/30 for the April 25 purchase on account. This means that Mario can receive a 2% discount if payment is made within 10 days, but the total invoice is due within 30 days. Mario's policy is to take advantage of discounts offered. Recall that on April 25 Mario purchased 300 units on account for $9 each (or $2,700 total).

When Mario makes payment on April 30, the discount would be $54 (= $2,700 × 2%). Mario has to pay only $2,646 (= $2,700 − $54) to eliminate the $2,700 amount owed. To account for the purchase discount, we subtract the discount from the balance in the Inventory account: April 30 debit accounts payable 2700 credit inventory 54 credit cash 2646 Just as freight charges add to the cost of inventory and therefore increase the cost of goods sold once those items are sold, purchase discounts subtract from the cost of inventory and therefore reduce cost of goods sold once those items are sold. When Mario sells the 300 units purchased on April 25, the cost of goods sold associated with those items will be the cost of the actual units ($2,700) plus freight charges ($300) less the purchase discount ($54), totaling $2,946.

notes receivable

When receivables are accompanied by formal credit arrangements made with written debt instruments (or notes), we refer to them as notes receivable.

net realizable value

When the value of inventory falls below its original cost, companies are required to report inventory at the lower net realizable value of that inventory. Net realizable value is the estimated selling price of the inventory in the ordinary course of business less any costs of completion, disposal, and transportation. In other words, it's the net amount a company expects to realize in cash from the sale of the inventory.

Acceptance of Customer Checks: Let's assume a local theatre sells tickets for the entire day totaling $3,000. Some customers pay cash for those tickets, while others use a check.

Whether a customer uses cash or a check to make a purchase, the company records the transaction as a cash sale. Regardless of which method of payment customers use, the theatre records all of those ticket sales as cash sales. Journal entry: Debit Cash 3,000 Credit Service Revenue 3,000

disadvantage of the allowance method

While the allowance method is conceptually superior to the direct write-off method and more accurately reports assets and matches revenues and expenses, it does have one disadvantage. This disadvantage arises from the fact that reported amounts under the allowance method represent management estimates. If so inclined, management could use these estimates to manipulate reported earnings. For example, if management wants to boost earnings in the current year, it can intentionally underestimate future uncollectible accounts. Similarly, if a company is having an especially good year and management wants to "reserve" earnings for the future, it can intentionally overestimate future uncollectible accounts. Having a large expense in the current year means there is less of a charge to bad debt expense in a future year, increasing future earnings. Other expenses, such as rent expense, are much more difficult to manipulate because their reported amounts don't rely on management estimates. These expenses are evidenced by past transactions, and their amounts are verifiable to the penny using a receipt or an invoice.

book value

also referred to as carrying value, equals the original cost of the asset minus the current balance in Accumulated Depreciation. Note that by increasing accumulated depreciation each period, we are reducing the book value of equipment. The Accumulated Depreciation account allows us to reduce the book value of assets through depreciation, while maintaining the original cost of each asset in the accounting records.

notes receivable

are similar to accounts receivable but are more formal credit arrangements evidenced by a written debt instrument, or note. Notes receivable typically arise from loans to other entities (including affiliated companies); loans to stockholders and employees; and occasionally the sale of merchandise, other assets, or services.

how we report inventory and why

as a current asset in the balance sheet an asset because it represents a valuable resource to the company, and current because the company expects to convert it to cash in the near term

Deposits Outstanding

cash receipts of the company that have not been added to the bank's record of the company's balance.

Checks Outstanding

checks the company has written that have not been subtracted from the bank's record of the company's balance.

The important point to understand is that all forms of cash and cash equivalents usually are _______ and reported as a _______ asset in the balance sheet of most companies. This balance is usually referred to as "cash" or "cash and cash equivalents."

combined;single

at the end of the period, the amount the company reports for inventory is the

cost of inventory not yet sold

Tangible assets such as land, land improvements, buildings, equipment, and natural resources are recorded at

cost plus all costs necessary to get the asset ready for its intended use.

The amount of cash recorded in a company's balance sheet includes

currency, coins, and balances in savings and checking accounts, as well as items acceptable for deposit in these accounts, such as checks received from customers. In addition, when a company sells products or services to customers who use credit cards or debit cards, the cash to be collected from those sales is nearly always included in the total cash balance immediately. The reason is that cash from those transactions typically will be deposited electronically into the company's bank account within a few days.

How would the patient, Justin Payne, record the previous transaction? By signing the note, Justin has an account payable that becomes reclassified as a note payable. He records the issuance of the note payable on February 1 as follows.

debit accounts payable 10000 credit notes payable 10,000 Just as one company's account payable is another company's account receivable, there is also a note payable for every note receivable. For every dollar a company earns in interest revenue, another company incurs a dollar of interest expense. We address notes payable in Chapter 8, but if you have a good understanding of notes receivable, then you have a head start with its flip side—notes payable.

To see how companies record credit sales, consider an example. Suppose Link's Dental charges $500 for teeth whitening. Dee Kay decides to have her teeth whitened on March 1 but doesn't pay cash at the time of service. She promises to pay the $500 whitening fee to Link by March 31. Link's Dental records the following at the time of the whitening.

debit accounts receivable credit service revenue

COLLECTION OF ACCOUNTS PREVIOUSLY WRITTEN OFF Later in 2019, on September 8, Bruce's bankruptcy proceedings are complete. Kimzey had expected to receive none of the $4,000 Bruce owed. However, after liquidating all assets, Bruce is able to pay each of his creditors 25% of the amount due them. So, when Kimzey receives payment of $1,000 (= $4,000 × 25%), it makes the following two entries.

debit accounts receivable 1000 credit allowance for uncollectible accounts 1000 debit cash 1000 credit accounts receivable 1000 The first entry simply reverses a portion of the previous entry that Kimzey made on February 23 to write off the account. The second entry records the collection of the account receivable. Notice that in both entries the debit entry increases total assets by the same amount that the credit entry decreases total assets. Therefore, collecting cash on an account previously written off also has no effect on total assets and no effect on net income. Of course, the two entries above could have been recorded as a single entry by debiting Cash and crediting Allowance for Uncollectible Accounts. The debit to Accounts Receivable in the first entry and the credit to Accounts Receivable in the second entry exactly offset one another. Two entries are used here to help emphasize (1) the reversal of the prior write off and (2) the cash collection on account. Continuing our example, suppose that by the end of 2019 total accounts written off by Kimzey equal $4 million. Because Kimzey allowed for bad debts by setting up the Allowance for Uncollectible Accounts for $5 million at the end of 2018, the write-offs in 2019 will have no effect on total assets or net income. But what about the remaining $1 million left in the balance of Allowance for Uncollectible Accounts? As we'll see next, the remaining balance of $1 million will affect our new adjustment in the following year. Writing off a customer's account as uncollectible reduces the balance of accounts receivable but also reduces the contra asset—allowance for uncollectible accounts. The net effect is that there is no change in the net receivable (accounts receivable less the allowance) or in total assets. We recorded the decrease to assets as a result of the bad debt when we established the allowance for uncollectible accounts in a prior year.

When recording a transaction, companies don't recognize trade discounts directly. Instead, they recognize trade discounts indirectly by recording the sale at the discounted price. For example, let's go back to Link's Dental, which typically charges $500 for teeth whitening. Assume that in order to entice more customers, Dr. Link offers a 20% discount on teeth whitening to any of his regular patients. Since Dee Kay is one of Dr. Link's regular patients, she can take advantage of the special discount and have her teeth whitened for only $400.

debit accounts receivable 400 credit service revenue 400

Loss on Retirement Retirement of Long-Term Assets Now assume that Little King retires the delivery truck instead of selling it. If, for example, the truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement as calculated in Illustration 7-24. sale amount credit $0 less: Original cost of truck $40,000 Less: accumulated depreciation (3 years x $7000/year) (21000) book value at the end of year 3 credit 19000 loss credit (19000)

debit accumulated depreciation 21000 debit loss 19000 credit equipment 40000

WRITING OFF ACCOUNTS RECEIVABLE: To continue with our example of Kimzey Medical Clinic, let's suppose that on February 23, 2019 (the following year), Kimzey receives notice that one of its former patients, Bruce Easley, has filed for bankruptcy protection against all creditors. Based on this information, Kimzey believes it is unlikely Bruce will pay his account of $4,000. Remember, Kimzey previously allowed for the likelihood that some of its customers would not pay, though it didn't know which ones. Now that it knows a specific customer will not pay, it can adjust the allowance and reduce the accounts receivable balance itself. Upon receiving news of this actual bad debt, Kimzey records the following.

debit allowance for uncollectible accounts 4000 credit accounts receivable 4000

INTANGIBLE ASSETS SUBJECT TO AMORTIZATION Most intangible assets have a finite useful life that we can estimate. The service life of an intangible asset usually is limited by legal, regulatory, or contractual provisions. For example, the legal life of a patent is 20 years. However, the estimated useful life of a patent often is less than 20 years if the benefits are not expected to continue for the patent's entire legal life. The patent for the Apple Watch, for example, is amortized over fewer than 20 years, since new technology will cause the watch to become outdated in a shorter period. The expected residual value of most intangible assets is zero. This might not be the case, though, if at the end of its useful life to the reporting entity the asset will benefit another entity. For example, if Apple has a commitment from another company to purchase one of its patents at the end of the patent's useful life at a determinable price, we use that price as the patent's residual value. Most companies use straight-line amortization for intangibles. Also, many companies credit amortization to the intangible asset account itself rather than to accumulated amortization. That's the approach illustrated in the chapter and the approach to be used for homework in Connect. However, using a contra account such as Accumulated Amortization is also acceptable in practice. Let's look at an example: In early January, Little King Sandwiches acquires franchise rights from University Hero for $800,000. The franchise agreement is for a period of 20 years. In addition, Little King purchases a patent for a meat-slicing process for $72,000. The original legal life of the patent was 20 years, and there are 12 years remaining. However, due to expected technological obsolescence, the company estimates that the useful life of the patent is only 8 more years. Little King uses straight-line amortization for all intangible assets. The company's fiscal year-end is December 31. Little King records the amortization expense for the franchise and the patent as follows.

debit amortization expense 40000 credit franchises 40000 40000=800000/20 years debit amortization expense 9000 credit patents 9000 9000=72000/8 years

To see how the direct write-off method works, suppose a company provides services on account for $100,000 in 2018, but makes no allowance for uncollectible accounts at the end of the year. Then, in the following year on September 17, 2019, an account of $2,000 becomes uncollectible. The company records the actual write-off as follows.

debit bad debt expense 2000 credit accounts receivable 2000

The adjusting entry at the end of 2018 to allow for future bad debts would instead be $5 million using the aging method.

debit bad debt expense 5 credit allowance for uncollectible accounts 5

ESTIMATING UNCOLLECTIBLE ACCOUNTS: To use the allowance method, a company first estimates at the end of the current year how much in uncollectible accounts will occur in the following year. Consider an example of future uncollectible accounts for Kimzey Medical Clinic, which specializes in emergency outpatient care. Because it doesn't verify the patient's health insurance before administering care, Kimzey knows that a high proportion of fees for emergency care provided will not be collected. Page 224 In 2018, its first year of operations, Kimzey bills customers $50 million for emergency care services provided. By the end of the year, $20 million remains due from customers. Those receivables are assets of the company. But how much of the $20 million does Kimzey expect not to collect in the following year? The receivables not expected to be collected should not be counted as assets. The credit manager at Kimzey estimates that approximately 30% of accounts receivable will not be collected. Estimating uncollectible accounts based on the percentage of accounts receivable expected not to be collected is known as the percentage-of-receivables method. This method sometimes is referred to as the balance sheet method, because we base the estimate of bad debts on a balance sheet amount—accounts receivable.4 Using the 30% estimate, Kimzey expects that $6 million of its accounts receivable (or 30% of $20 million) likely will never be collected. It makes the following year-end adjustment to allow for these future uncollectible accounts.

debit bad debt expense 6 credit for uncollectible accounts 6

Loss on Sale If we assume that Little King sells the delivery truck at the end of year 3 for only $17,000 instead of $22,000, we have a $2,000 loss as calculated in Illustration 7-23. In this case, the sale amount is less than the truck's book value. If we assume that Little King sells the delivery truck at the end of year 3 for only $17,000 instead of $22,000, we have a $2,000 loss as calculated in Illustration 7-23. In this case, the sale amount is less than the truck's book value.

debit cash 17000 debit accumulated depreciation 21000 debit loss 2000 credit equipment 40000

For demonstration, let's assume the local Starbucks pays $1,200 for equipment—say, an espresso machine. The machine is expected to have a service life of four years. We record annual depreciation as shown below.

debit depreciation expense 300 credit accumulated depreciation 300 300=1200/4 years

Gain on Exchange Exchange of Long-Term Assets Now assume that Little King exchanges the delivery truck at the end of year 3 for a new truck valued at $45,000. The dealership gives Little King a trade-in allowance of $23,000 on the exchange, with the remaining $22,000 paid in cash. We have a $4,000 gain, as calculated in We record the gain on exchange as:

debit equipment (new) 45000 debit accumulated depreciation 21000 credit cash 22000 credit equipment (old) 40000 credit gain 4000

Accounting for Notes Receivable: As an example, let's say that, on February 1, 2018, Kimzey Medical Clinic provides services of $10,000 to a patient, Justin Payne, who is not able to pay immediately. In place of payment, Justin offers Kimzey a six-month, 12% promissory note. Because of the large amount of the receivable, Kimzey agrees to accept the promissory note as a way to increase the likelihood of eventually receiving payment. In addition, because of the delay in payment, Kimzey would like to charge interest on the outstanding balance. A formal promissory note provides an explicit statement of the interest charges.

debit notes receivable credit service revenue

Suppose on March 5, after she gets her teeth whitened but before she pays, Dee notices that another local dentist is offering the same procedure for $350, which is $50 less than Link's discounted price of $400. Dee brings this to Dr. Link's attention and because his policy is to match any competitor's pricing, he offers to reduce Dee's account balance by $50. Link's Dental records the following sales allowance.

debit sales allowance 50 accounts receivable 50

On December 15, Mario sold another 500 units for $15 each on account. Again, we make two entries to record the sale. The first entry increases Accounts Receivable and Sales Revenue. The second entry adjusts the Cost of Goods Sold and Inventory accounts. What did the inventory sold on December 15 cost Mario? On the FIFO basis, the cost of goods sold is $5,300 (100 units × $9 plus 400 units × $11). Mario increases Cost of Goods Sold and decreases Inventory by that amount. Thus, we record the sale on December 15 as:

december 15 debit accounts receivable 7,500 credit sales revenue 7,500 debit cost of goods sold 5,300 credit inventory 5,300 After recording all purchases and sales of inventory for the year, we can determine the ending balance of Inventory by examining the postings to the account. Thus, Mario's ending Inventory balance is $2,200, as shown in Illustration 6-13. Refer back to Illustration 6-6 to verify the ending balance of inventory using FIFO.

Mario reports the Funstation 2 in ending inventory at net realizable value ($200 per unit) because thats lower than its original cost ($300 per unit). the 15 funstation 2s were originally reported in inventory at their cost of $4500(=15 x $300). to reduce the inventory from that original cost of $4500 to its lower net realizable value of $3000(=15 x $200), mario records a $1500 reduction in inventory with the following year-end adjustment

december 31 debit cost of goods sold (expense) 1500 credit inventory 1500

type of expenditure: additions

def: adding a new major component period benefited: future usual accounting treatment: capitalize

type of expenditure: legal defense of intangible assets

def: incurring litigation costs to defend the legal right to the asset period benefited: future usual accounting treatment: capitalize (expense if defense is unsuccessful)

type of expenditure: improvements

def: replacing a major component period benefited: future usual accounting treatment: capitalize

type of expenditure: repairs and maintenance definition: maintaining a given level of benefits

definition: maintaining a given level of benefits period benefited: current usual accounting treatment: expense

It is important to emphasize that the direct write-off method is not allowed for

financial reporting under GAAP It is only used in financial reporting if uncollectible accounts are not anticipated or are expected to be very small.

type of cash flow and inflow or outflow: obtain a loan at the bank

financing inflow

say which type of activity, is cash involved, and if its inflow or outflow: borrow $10,000 from the local bank and sign a note promising to repay the full amount of the debt in three years

financing yes inflow

say which type of activity, is cash involved, and if its inflow or outflow: pay cash dividends of 200 to shareholders

financing yes outflow

say which type of activity, is cash involved, and if its inflow or outflow: sell shares of common stock for $25,000 to obtain the funds

financing yes inflow

Using the periodic inventory system, we record purchases

freight-in, purchase returns, and purchase discounts to temporary accounts rather than directly to Inventory. These temporary accounts are closed in a period-end adjustment. In addition, at the time inventory is sold, we do not record a decrease in inventory sold; instead, we update the balance of Inventory in the period-end adjustment.

inventory

includes items a company intends for sale to customers

Accountants often call LIFO the

income-statement approach: The amount it reports for cost of goods sold (which appears in the income statement) more realistically matches the current costs of inventory needed to produce current revenues. Recall that LIFO assumes the last purchases are sold first, reporting the most recent inventory cost in cost of goods sold. However, also note that the most recent cost is not the same as the actual cost. FIFO better approximates actual cost of goods sold for most companies, since most companies' actual physical flow follows FIFO.

The one issue that usually applies to notes receivable but not to accounts receivable is

interest

interest calculation

interest = face value x annual interest rate x fraction of the year

perpetual inventory system: -When companies purchase inventory using a perpetual inventory system, they increase the ____ account and either decrease ____ or increase _____ ______ When companies sell inventory, they make two entries:

inventory cash accounts payable (1) They increase an asset account (Cash or Accounts Receivable) and increase Sales Revenue, and (2) they increase Cost of Goods Sold and decrease Inventory.

type of cash flow and inflow or outflow: purchase a building with cash

investing outflow

say which type of activity, is cash involved, and if its inflow or outflow: purchase equipment necessary for giving golf training, $24,000 cash

investing yes outflow

profit margin

is calculated as net income divided by net sales. This ratio indicates the earnings per dollar of sales

Asset turnover

is calculated as net sales divided by average total assets. This ratio measures the sales per dollar of assets invested.

the upside of extending credit to customers by allowing them to purchase on account?

it boosts sales by allowing customers the ability to purchase on account and pay cash later. Just think of how many times you wanted to buy food, clothes, electronics, or other items, but you didn't have cash with you. You're not alone. Many customers may not have cash readily available to make a purchase or, for other reasons, simply prefer to buy on credit.

The property, plant, and equipment category consists of

land, land improvements, buildings, equipment, and natural resources.

Differences in these balances most often occur because

of either timing differences or errors. It is the possibility of these errors, or even outright fraudulent activities, that makes the bank reconciliation a useful cash control tool. A bank reconciliation connects the company's cash balance to the bank's cash balance by identifying differences due to timing and errors.

say which type of activity, is cash involved, and if its inflow or outflow: provide golf training to customers on account 2000

operating no -

type of cash flow and inflow or outflow: pay employees salaries

operating outflow

say which type of activity, is cash involved, and if its inflow or outflow: Receive cash in advance for 12 gold training sessions to be given in the future 600

operating yes inflow

say which type of activity, is cash involved, and if its inflow or outflow: provide golf training to customers for cash 4300

operating yes inflow

say which type of activity, is cash involved, and if its inflow or outflow: pay one year of rent in advance, $6,000 (500 per month)

operating yes outflow

say which type of activity, is cash involved, and if its inflow or outflow: pay salaries to employees 2800

operating yes outflow

say which type of activity, is cash involved, and if its inflow or outflow: purchase supplies on account, 2300

operating no -

type of expenditure: repairs and maintenance definition: making major repairs that increase future benefits

period benefited: future usual accounting treatment: capitalize

INVENTORY PURCHASES AND SALES The final two transactions are (1) the purchase of 600 additional units of inventory for $6,600 on account on October 19 and (2) the sale of 500 units for $7,500 on account on December 15. We record that transaction as follows.

perpetual system debit inventory 6600 credit accounts payable 6600 periodic system debit purchases 6600 credit accounts payable 6600 perpetual system debit accounts receivable 7500 credit sales revenue 7500 periodic system debit accounts receivable 7500 credit sales revenue 7500 no entry for cost of goods sold

PERIOD-END ADJUSTMENT A period-end adjustment is needed only under the periodic system. The adjustment serves the following purposes: 1. Adjusts the balance of inventory to its proper ending balance. 2. Records the cost of goods sold for the period, to match inventory costs with the related sales revenue. 3. Closes (or zeros out) the temporary purchases accounts (Purchases, Freight-in, Purchase Discounts, and Purchase Returns). Let's see what the period-end adjustment would look like for Mario's Game Shop using the transactions described in this appendix. In addition, recall that beginning inventory equals $700 (= 100 units × $7 unit cost) and ending inventory equals $1,650 (= 150 units × $11 unit cost).

perpetual system no entry periodic system debit inventory(ending) 1650 debit cost of goods sold 8046 debit purchase discounts 54 debit purchase returns 550 credit purchases 9300 credit freight-in 300 credit inventory (beginning) 700 Notice that (1) the balance of Inventory is updated for its ending amount of $1,650, while its beginning balance of $700 is eliminated, (2) Cost of Goods Sold is recorded for $8,046, and (3) temporary accounts related to purchases are closed to zero. Purchase Discounts and Purchase Returns are credit balance accounts so they need to be debited to close them. Likewise, Purchases and Freight-in are debit balance accounts so they need to credited to close them.

INVENTORY PURCHASES AND SALES The first transaction on April 25 involves the purchase of $2,700 of inventory on account. Under the periodic system, instead of debiting the Inventory account, we debit a Purchases account. Remember, we're not continually adjusting the Inventory account under the periodic method. We use the Purchases account to temporarily track increases in inventory.

perpetual system: debit inventory 2700 credit accounts payable 2700 periodic system: debit purchases 2700 credit accounts payable 2700

INVENTORY PURCHASES AND SALES The transaction on July 17 involves the sale on account of 300 units of inventory for $4,500. We record that transaction as follows.

perpetual system: debit accounts receivable 4500 credit sales revenue 4500 debit cost of goods sold 2500 credit inventory 2500 periodic system debit accounts receivable 4500 credit sales revenue 4500 no entry for cost of goods sold

A multiple-step income statement reports multiple levels of _____ 1. gross profit 2. operating income 3. income before income taxes 4. net income

profitability 1. equals net revenues (or net sales) minus cost of goods sold. 2. equals gross profit minus operating expenses. 3. equals operating income plus nonoperating revenues and minus nonoperating expenses. 4. equals all revenues minus all expenses.

tangible assets are also referred to as what

property, plant, and equipment

merchandising companies

purchase inventories that are primarily in finished form for resale to customers. These companies may assemble, sort, repackage, redistribute, store, refrigerate, deliver, or install the inventory, but they do not manufacture it. They simply serve as intermediaries in the process of moving inventory from the manufacturer, the company that actually makes the inventory, to the end user.

nontrade receivables

receivables that originate from sources other than customers. They include tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees.

multiple-step income statement

referring to the fact that the income statement reports multiple levels of income (or profit). The reason why companies choose the multiple-step format is to show the revenues and expenses that arise from different types of activities. By separating revenues and expenses into their different types, investors and creditors are better able to determine the source of a company's profitability. Understanding the source of current profitability often enables a better prediction of future profitability. Levels of profitability: gross profit, operating income, income before income taxes, net income

trade discounts

represent a reduction in the listed price of a product or service. Companies typically use trade discounts to provide incentives to larger customers or consumer groups to purchase from the company. Trade discounts also can be a way to change prices without publishing a new price list or to disguise real prices from competitors.

accounts receivable

represent the amount of cash owed to a company by its customers from the sale of products or services on account. To understand accounts receivable, we need to start with credit sales, from which accounts receivable originate.

sales discount

represents a reduction, not in the selling price of a product or service, but in the amount to be paid by a credit customer if payment is made within a specified period of time. It's a discount intended to provide incentive for quick payment.

Purchase Discounts

sellers often encourage prompt payment by offering discounts to buyers. From the seller's point of view, these are sales discounts; from the buyer's point of view, they are purchase discounts. Purchase discounts allow buyers to trim a portion of the cost of the purchase in exchange for payment within a certain period of time. Buyers are not required to take purchase discounts, but many find it advantageous to do so.

inventory turnover ratio

shows the number of times the firm sells its average inventory balance during a reporting period Cost of Goods Sold/Average Inventory average inventory is goung by doing (beginning inventory+ending inventory)/2 The amount for cost of goods sold is obtained from the current period's income statement; average inventory equals the average of inventory reported in this period's and last period's balance sheets. Last period's ending inventory is this period's beginning inventory. The more frequently a business is able to sell or "turn over" its average inventory balance, the less the company needs to invest in inventory for a given level of sales. Other things equal, a higher ratio indicates greater effectiveness of a company in managing its investment in inventory.

Freight Charges

significant cost associated with inventory for most merchandising companies includes freight (also called shipping or delivery) charges. This includes the cost of shipments of inventory from suppliers, as well as the cost of shipments to customers. When goods are shipped, they are shipped with terms FOB shipping point or FOB destination. FOB stands for "free on board" and indicates when title (ownership) passes from the seller to the buyer. FOB shipping point means title passes when the seller ships the inventory, not when the buyer receives it. In contrast, if the seller ships the inventory FOB destination, then title transfers to the buyer when the inventory reaches its destination.

FIFO more closely resembles what conversely, LIFO results in

the actual physical flow of inventory. When inventory costs are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in the income statement. LIFO results in a lower reported inventory and net income, reducing the company's income tax obligation.

net realizable value

the amount of cash the firm expects to collect

cost of goods sold (or cost of sales, cost of merchandise sold, or cost of products sold)

the company reports the cost of the inventory sold as this in the income statement

fraud triangle

top: opportunity- the situation allows the fraud to occur bottom: motivation- someone feels the need to commit fraud, such as the need to money Rationalization- justification for the deceptive act by the one committing the fraud

Credit sales

transfer products and services to a customer today while bearing the risk of collecting payment from that customer in the future. Credit sales transactions are also known as sales on account. Similarly, credit service transactions are also called services on account. Companies often combine total sales revenues with total service revenues in reporting total revenues on the income statement. As we saw in the opening story, Tenet Healthcare provides a considerable amount of healthcare-related sales and services on credit, but many of its credit customers never pay. In this chapter, we focus on recording sales or services on credit and dealing with the likelihood that some customers will not pay as promised.

Customers' accounts that we no longer consider collectible

uncollectible accounts, or bad debts.

Along with the recognized revenue, at the time of sale the seller also obtains a legal right to receive cash from the buyer. The legal right to receive cash is

valuable and represents an asset of the company. This asset is referred to as accounts receivable (sometimes called trade receivables), and the firm records it at the time of a credit sale.

what we do on the left side (bank cash balance) of the bank reconciliation

we adjust the bank's cash balance by adding deposits outstanding and subtracting checks outstanding. We would also need to look for and correct any bank errors, but there are none here.

periodic inventory system

we do not continually modify inventory amounts. Instead, we periodically adjust for purchases and sales of inventory at the end of the reporting period, based on a physical count of inventory on hand