Financial Accounting

25/2/2019 Financial Accounting
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Financial Accounting
Pretest Introduction
Welcome to the pre-assessment test for the Financial Accounting Online Course. This test will allow you to assess your knowledge of basic and advanced financial accounting.
All questions must be answered for your exam to be scored.
Navigation:
To advance from one question to the next, select one of the answer choices or, if applicable, complete with your own choice and click the “Submit” button. After submitting your answer,
you will not be able to change it, so make sure you are satisfied with your selection before you submit each answer. You may also skip a question by pressing the forward advance arrow.
Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a question,
you must navigate back to it and answer it - all questions must be answered for the exam to be scored.
Your results will be displayed immediately upon completion of the exam.
After completion, you can review your answers at any time by returning to the exam.
Good luck!
Welcome to Financial Accounting

You are about to begin an interactive experience that will introduce you to financial accounting, the language of business. Successful completion of this course will enable you to
understand how accounting systems are used to record the day-to-day economic activities of a business and to generate reports about its financial health and performance.
Using the Tutorial

The structure of the HBS Financial Accounting Tutorial and its navigational tools are easy to master. If you're reading this text, you must have clicked on the navigation item labeled
"Using the Tutorial" on the left.
Please click on the Help icon in the upper right corner of the tutorial to view a clickable animation on how to use this tutorial.
The Setting
This HBS Financial Accounting Tutorial uses a business context to help you learn the fundamentals of financial accounting.
You are setting up a store called Global Grocer. It will carry gourmet foods and condiments, unusual spices and specialty kitchen implements from all over the world. Global Grocer is a
franchise business - it will pay a franchising company, Global Grocer International, a franchise fee for the use of the name and for marketing support. You are planning to have a grand
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store opening in early September, with a big sale on items related to various fall and harvest celebrations around the world.
You have a limited amount of cash available to start up the business, but you hope to obtain bank loans and also raise capital from outside investors. You will be keeping the accounts (or
bookkeeping) for the Global Grocer store. Completing this tutorial will prepare you for that role.
The Accounting Process

This tutorial is based on a model of the accounting process in a small business.
Financial accounting is a financial information system that tracks and records an organization's business transactions and aggregates them into reports for decision makers both inside
and outside the business. A transaction is an event that has consequences for a business' financial condition. The event could be either external or internal to the business.
(1) In the running of a business, various decisions are made and implemented as business transactions. For example, in a typical business, managers will raise capital from investors and
banks, rent or buy equipment, and purchase and sell merchandise and services. Each business transaction is related to one of three types of activities: operating, investing and financing
activities.
(2) Even the most simple organizations have numerous business transactions that have to be tracked and recorded. Transactions are formally recorded in a database called a journal,
and then organized by accounts into a ledger.
(3) Report preparation requires the aggregation of accounting transactions into statements or reports that describe the financial status of the business and its performance. The most
common financial accounting reports are the balance sheet, the income statement and the statement of cash flows.
(4) Financial statements are used by decision makers inside and outside the business. For example, managers use them to decide whether the firm is making a profit, whether customer
incentives are working, or whether to take a loan and expand the business.
If a business raises capital from outside investors, the investors will examine the company's financial statements to judge whether the funds they have invested have been used wisely.
(5) Financial reporting concepts and principles tell us when and how to measure, record and classify business transactions and aggregate them into financial reports. By following these
concepts and principles, financial reporting systems provide information that is consistent over time and across different businesses, and accounting becomes a language that is widely
understood.
(6) Auditors are independent parties who periodically examine a company's financial statements and the systems, internal controls and records used to produce the statements. Since a
company's managers prodice their own report cards, i.e., the company's financial statements, auditors play an important role as a control mechanism. They attest that the financial
statements conform to generally accepted accounting principles and they provide assurance that the company's accounts are presented fairly.
(7) Based on their analyses of financial statements, financial statement users take actions, which in turn, affect the future operating, investing and financing decisions made by the
organization. Hence, the financial reporting system is an information feedback loop between users of financial statements and the decision makers within the organization.
Module Overview
In each chapter of this tutorial, you will learn new financial accounting terms and concepts and how to use this knowledge within the context of the Global Grocer setting. You will also
be given exercises to practice and test what you have learned at several points in each chapter.
The "Terms and Concepts" chapter introduces key financial accounting terms and five fundamental financial accounting concepts. It provides a brief overview of the three most
important financial statements.
The chapters labeled "The Balance Sheet," "The Income Statement," and "The Statement of Cash Flows" explain relevant new financial accounting concepts and use the concepts to
construct a financial statement. You will see how Global Grocer's financial statements are affected by its business transactions during the first month of operations.
In the "Accounting Records" chapter you will learn how to formally record Global Grocer's business transactions into its journal and ledger and how to use these records to prepare its
financial statements. In doing so, you will revisit and record all the events that occurred at Global Grocer during the first month; only, this time, you will use the formal bookkeeping
structures used in financial accounting systems.
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Module Overview (continued)

Chapters 1 through 6 cover the financial reporting basics. Beginning in Chapter 7, "Revenues and Receivables," you will begin learning about more advanced financial reporting topics.
The advanced accounting chapter labels are indicative of the topic covered. These include "Inventories and Cost of Sales," "Depreciation and Long-Lived Assets," "Liabilities and
Financing Costs," "Investments and Investment Income," "Deferred Taxes and Tax Expense," and "Owners' Equity." In each of these chapters you will have to resolve a set of accounting
challenges facing Global Grocer. Your solutions to those accounting challenges will build on the basic financial accounting knowledge you acquired in your study of Chapters 1 - 6.
As you will learn, accounting practices in the United States are governed by a set of accounting rules referred to as Generally Accepted Accounting Principles (GAAP). These rules and
their applications are covered in depth in this tutorial. Accounting practices outside of the United States are usually governed by GAAP’s international counterpart, the International
Financial Reporting Standards (IFRS). This tutorial, where appropriate, refers to both sets of standards.
Exercise 1.1
Financial accounting is an information system that
Choose the word that best completes the following sentence: In financial accounting, an organization's business transactions are classified into operating activities, _________
activities and financing activities.
Since auditors have to attest to the validity of a company's financial statements, what is an important characteristic for an auditor from the following choices?
Terms and Concepts

In this chapter, you will explore the three main financial statements in some detail, and you will be introduced to five basic financial accounting concepts: entity, money measurement,
going concern, consistency and materiality. You will also learn about two important qualities of financial accounting information--relevance and reliability--and how the use of accrual
accounting and generally accepted accounting principles aid accountants in their quest for these qualities.
Overview of Financial Reports

In this section, you will be introduced to the three main financial reports or statements. Each statement will be covered in more detail in the following chapters.
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Balance Sheet
A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and
owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account.
This is Global Grocer's balance sheet one month after it opens for business. We will use it to explain key balance sheet-related terms. The chapter labeled "The Balance Sheet" covers
the balance sheet in more detail.
(1) At top of each financial statement is the name of the organization or entity for which the statement has been prepared. The term entity is used to indicate the separate economic
unit for which financial records are being kept and financial statements prepared. Common types of accounting entities are businesses, political and charitable organizations, city
governments, universities...any organization that needs to record and communicate its financial activities.
(2) A balance sheet, also called a statement of financial position, is a report of the organization's financial situation at a particular point in time. It lists the entity's assets, liabilities and
owners' equity. It is called a balance sheet because it reports the balance or amount in each asset, liability and owners' equity account. Chapter 3 covers the balance sheet in greater
detail.
(3) Each balance sheet is prepared as of a specific date, which is recorded at the top of the statement. In the next chapter, you will prepare this opening balance sheet for Global
Grocer, dated August 31, 2004.
(4) Assets are economic resources acquired in a business transaction that are obtained or controlled by an entity, and are expected to produce future economic benefits. For example,
this balance sheet shows that on September 30, 2004, among other assets, Global Grocer had a cash asset recorded at $95,500 and a warehouse property (building and land) recorded
at $69,700.
(5) A liability is an obligation to transfer economic resources to entities outside the business. Liabilities represent the capital provided to the business by creditors. For example, a loan
from a bank is a liability, such as the one listed on Global Grocer's Spetember 30, 2004 balance sheet as short-term debt. Under the loan contract, Global Grocer has an obligation to
repay the bank from which it obtained the loan.
(6) Owners' Equity, also known as stockholders' or shareholders' equity, represents the residual interest of the owners in the business. The owners' interest is what's left over after
deducting liabilities from assets. The common stock listed on Global Grocer's Spetember 30, 2004 balance sheet indicates that its owners have contributed capital to the company,
and in return, have received common stock certificates establishing their ownership interest.
Income Statement
The income statement details the entity's operating performance during a specific period of time, known as the accounting period, displayed at the top of the statement. In this income
statement for Global Grocer, the accounting period is the month of September 2014.
The income statement lists the revenues earned and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the
period.
The chapter labeled "The Income Statement" covers the income statement in greater detail.
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(1) Just as in the balance sheet, the income statement contains the name of the entity at the top.
(2) The income statement details the entity's operating performance during a specific period of time known as the accounting period. The income statement lists the revenues earned
and expenses incurred during the period; subtracting expenses from revenues results in the measurement of net income for the period. Chapter 4 covers the income statement in
greater detail.
(3) The date is displayed at the top of the statement. In this example income statement for Global Grocer, the accounting period is the month of September 2004.
(4) Sales, sometimes denoted as Sales revenue or Revenues, is the sum of the economic benefits the entity has earned during the accounting period in exchange for the goods and
services it has provided to its customers. The economic benefits may be increases in assets or decreases in liabilities.
(5) Expenses are the assets used or liabilities incurred by the entity during an accounting period to provide the goods and services that generated revenue during the period.
(6) Net income or profit, or net profit, is the difference between the sales and expenses of the accounting period. Because it appears as the last line of the income statement, it is often
referred to as the bottom line.
Statement of Cash Flows

The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash flows
is organized by type of business activity: operating, investing and financing.
The chapter labeled "The Statement of Cash Flows" covers the statement of cash flows in greater detail.
(1) Just as in the balance sheet and the income statement, the statement of cash flows indicates the name of the entity at the top.
(2) The statement of cash flows details the sources and uses of cash by the entity over an accounting period. For the convenience of financial statement users, the statement of cash
flows is organized by type of business activity: operating, investing and financing. Chapter 6 covers the statement of cash flows in greater detail.
(3) The date is displayed at the top of the statement. In this statement of cash flows for Global Grocer, the accounting period is the month of September 2004.
(4) Operating activities are those activities that are related to the delivery of goods and services. The cash impact of such activities is recorded in the operating activities section of the
statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report cash collected from customers, cash paid to suppliers and cash paid to
employees as part of its daily business activities.
(5) Investing activities are those activities that are related to the purchase and sale of long-lived assets. The impact of such activities on the cash account is recorded in the investing
activities section of the statement of cash flows. At Global Grocer, this section of the statement of cash flows would, for example, report the cash used to purchase a van.
(6) Financing activities relate to borrowing or retiring debt and to increasing or decreasing owners' equity in the firm. The impact of such activities on the cash account is recorded in
the financing activities section of the statement of cash flows. At Global Grocer, cash from bank loans and amounts received from owners are reported in this section of the statement
of cash flows.
Exercise 2.1
The Balance Sheet is so named because
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A balance sheet is prepared _________.
An income statement is prepared __________.
A statement of cash flows is prepared _________.
Choose the pair of words that best completes the following sentence: Cash held by a business would best be listed as _________ on the balance sheet; a bank loan taken by the
business would be listed as _________.
Classify the following as Operating, Investing or Financing activities:
Purchase or sale of building
Raising cash from investors
Selling products and services
Introduction to Concepts
Financial Accounting concepts form the foundation on which the financial accounting system and reports are built. Entities and the nature of their economic activities change and evolve
over time. Accounting must be able to accommodate and reflect those changes. Accounting concepts provide guidance to resolve accounting issues that may arise today or in the future.
In the United States, the Financial Accounting Standards Board (FASB) sets accounting standards. It has adopted a set of essential accounting concepts. They form the basis of a large
number of accounting standards that provide guidance to accountants on how to account for specific types of transactions. These standards and the details on how to apply them, if
printed in hard copy, would number in the thousands of pages.
Five broad accounting concepts - entity, money measurement, going concern, consistency and materiality - will be discussed in this section. Other concepts will be discussed in
subsequent chapters.
Entity Concept
The entity concept is the most basic accounting concept. It states that accounts are kept for an entity as distinct from the people who own, run or do business with the entity.
The entity concept is simple but powerful. It allows the accountant to draw a virtual boundary around the entity and hence limit the activities that need to be tracked and recorded.
Money Measurement Concept

The money measurement concept states that financial accounting deals only with things that can be represented in monetary terms. This concept is so intuitive that it is usually
taken for granted. But, since it is so important, it is stated as a basic accounting concept.
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Going Concern Concept

Going concern is accounting's way of saying that an entity is expected to remain in operation for the indefinite future. The going concern concept directs the accountant to
explicitly make this assumption in the absence of evidence to the contrary.
The significance of the going concern concept can be understood by considering the alternative: that the entity is about to go out of business. If this was the case, all its resources
should be valued at their current worth to potential buyers. The going concern concept directs the accountant, under the normal course of business, to ignore this doomsday scenario.
Consistency Concept
The consistency concept states that an entity should use the same accounting methods and procedures from period to period unless it has a sound reason to change methods.
The consistency concept needs to be explicitly stated because some accounting standards allow a fair degree of variation in how transactions are recorded. The consistency concept
reduces the likelihood of opportunistic or whimsical changes in accounting procedures by an entity.
Note that the consistency concept does not forbid a switch in accounting procedures. If an entity does make a procedural accounting change, its management and auditors are
required to note the change in their discussion of the entity's accounts.
Note also that in the context of accounting concepts, consistency means consistency over time.
Materiality Concept
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The materiality concept states that an entity need only apply proper accounting to items that are material, i.e., significant to potential users of the financial statements. This
concept allows the accountant to be practical in choosing the appropriate degree of precision in the accounts.
Just what is material and not material is not made specific in accounting. The general rule is that, "An item is material if its disclosure would impact the decisions of the users of the
accounts." The application of this rule requires accountants to judge what users of financial statements would consider significant to their decisions. As in most matters requiring
judgments, reasonable people can differ. Determining materiality is no exception.
Exercise 2.2
A non-profit agency cannot be a financial accounting entity.
Global Grocer is the entity for which you will keep the books. Which of the following events will affect Global Grocer's accounts?
Which of the following will not be recorded on Global Grocer's books because it violates the Money Measurement concept?
"Accounting does not report what the assets of a business could be sold for if the business ceased to exist." This is a result of the _______ concept.
Quality Attributes
In any financial accounting system, there are a number of decisions to be made: whether to record a transaction, when to record it and how to record it. Also, there are different ways to
aggregate the account balances in financial reports. Any such system must have a set of criteria or guidelines to help make those decisions. This section addresses some of those issues. It
discusses desired financial accounting quality attributes and some of the guidance that flows from these attributes.
Relevance and Reliability

In financial accounting, the quality of the output depends on the relevance and reliability of the data presented.
Relevance refers to the timeliness and usefulness of the information to its users. Reliability refers to the objectivity and verifiability of the information. Different ways of recognizing,
measuring and recording an event may yield more or less reliable or more or less relevant account balances.
Often, judgment has to be used to make the trade-off between relevance and reliability, i.e., there isn't a way to record a transaction that will maximize both these desirable properties.
In such cases, reliability is generally given precedence over relevance.
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Exercise 2.3
Choose the pair of words that best completes the following sentence: Since financial accounting reports are used to make decisions that affect the entity, financial accounting strives
to present information about the entity that is __________ and _________.
Choose the pair of words that best completes the following sentence: Relevance of financial information refers to its ___________ and ___________.
Which of the following pairs of attributes best contributes to the reliability of financial data?
When relevance and reliability are in conflict, financial accounting will favor relevance.
Accrual Accounting
Accrual accounting is an important tool in the quest for relevance in accounting reports. This method of accounting provides information about a company's assets, liabilities and
owners' equity that cannot be obtained by accounting for only cash receipts and outlays.
Accrual accounting focuses on the economic characteristics of transactions rather than their cash flows.
Accrual vs. Cash-Basis

Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the
transaction occurs rather than only in the periods when cash is received or paid by the company.
At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting.
When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash-basis accounting results in inadequate and misleading financial
statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today.
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Accrual accounting attempts to record the financial effects on a business of transactions that have economic consequences for the business in the accounting period when the
transaction occurs rather than only in the periods when cash is received or paid by the company.
At this stage, some simple examples will help give meaning to the term accrual accounting as contrasted with cash-basis accounting.
When applied consistently, accrual accounting is a means of enhancing the relevance of financial statements. Cash-basis accounting results in inadequate and misleading financial
statements for all but the most simple of businesses. As a result, accrual accounting is the accounting system of choice throughout the world today.
GAAP
Financial accounting reports are used by investors, regulators, employees, customers and a number of other external parties. So that this diverse list of users can understand an entity's
financial statements, accountants must follow certain guidelines or standards when preparing financial accounting reports. These principles, more numerous than the accounting
concepts, are explicit rules that are used to improve the reliability and comparability of financial reports.
Generally Accepted Accounting Principles (GAAP) are guidelines that accountants, managers and auditors must follow while preparing and auditing accounting information for external
reporting purposes. For example, GAAP requires the use of accrual accounting. The application of GAAP rules results in reasonably reliable financial information, while also permitting
each entity to reasonably describe its own business strategy and performance through relevant accounting information.
In this tutorial, you will use GAAP to record Global Grocer's business transactions. However, you will not need to actually look up or refer to the Generally Accepted Accounting
Principles each time. Instead, this tutorial will simply show you how to record Global Grocer's transactions according to GAAP.
The Financial Accounting Standards Board (FASB) determines GAAP in the United States. There also exists an International Accounting Standards Board (IASB), which, among other
activities, has undertaken a major effort to harmonize accounting standards around the world.
IFRS
The International Accounting Standards Board (IASB) publishes International Financial Reporting Standards (IFRS). Users of this tutorial can assume, unless noted otherwise, that the
accounting for a particular transaction described in the tutorial is essentially the same under both GAAP and IFRS.
Principles vs Rules
Principles Based versus Rules Based
IFRS tends to be stated as in the form of broad principles. In contrast, much of GAAP tends to be stated in the form of bright-line rules. For example, as you will learn later along with
various accounting rules, under GAAP if a term of a lease is equal to 75 percent of the economic life of the leased property, the lease will be accounted for as a capital lease. On the other
hand, if the lease item is equal to 74 percent or less of the leased property's economic life, the lease will be accounted for as an operating lease. IFRS takes a different approach. It makes
the distinction between a capital and an operating lease based on which party - the lessor or the lessee - substantially bears the risk and reward of ownership.
The distinction between the principle based and rule based accounting standards is important. Under a principle standards model, the accounting for transactions is more likely to
reflect the substance of the transaction. Under a rule based standards model, the accounting for a transaction is more likely to reflect the form of the transaction.
As GAAP and IFRS converge, it is anticipated that GAAP will become more principle based.
Recap
In this chapter, you have
briefly explored three fundamental accounting statements,
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learned about the entity concept, the money measurement concept, the going concern concept, the consistency concept and the materiality concept,
started to appreciate the inherent conflict between relevance and reliability that accountants must resolve in setting standards and preparing financial reports,
been introduced to accrual accounting and GAAP and their use in financial accounting practice, and
learned that in the near future GAAP may be replaced by IFRS.
The Balance Sheet

In this chapter, you will learn how a balance sheet is organized and about its main organizing principle, the accounting equation. Two concepts that are important for the preparation of
the balance sheet, dual aspect and historical cost, will be explained. They will be used to record the operating, investing and financing activities you have undertaken to get Global Grocer
ready for business. Finally, two financial ratios that can be computed from the balance sheet--current ratio and total debt to equity ratio--will be discussed.
Layout
The balance sheet, also known as a statement of financial position, is a snapshot at a specific point in time, of the resources controlled by an entity (assets), the claims against those
resources (liabilities), and the owners' residual interest in the entity (owners' equity). In the side-by-side format shown, assets are listed on the left side of the balance sheet; liabilities
and owners' equity are listed on the right.
Here is Global Grocer's balance sheet as it will appear at the end of business on September 30, after a month of operations.
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(1) Global Grocer, Inc.—is named at the top, and the balance sheet date is indicated. This is Global Grocer's balance sheet as it will appear at the end of business on September 30, 2004,
after a month of operations.
(2) In the side-by-side format shown, the entity's assets are listed on the left; its liabilities and owners' equity are listed on the right. Note that total assets equals total liabilities plus
owners' equity.
Exercise 3.1
Which one of the following best describes a balance sheet?
Assets
Let's now look at the left-hand side of the balance sheet. It lists the asset accounts, which represent the economic resources of the firm. To be recorded as an asset, an economic resource
must meet four requirements:
Acquired at measurable cost

Obtained or controlled by the entity
Expected to produce future economic benefits
Arises from a past transaction or event
Asset Examples
Here are three assets that you will record on Global Grocer's August 31, 2014, balance sheet (not shown). Each satisfies all four criteria for being recorded as an asset.
Not Assets
Here are some items that Global Grocer will not list as assets on its balance sheet. Each fails to satisfy at least one of the four criteria for being recorded as an asset.
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Tangibility
An item can be an asset whether or not it has physical substance, i.e., whether or not it can be touched and felt. Assets like computers and buildings having physical substance are
tangible assets. Other assets, like licenses and prepaid expenses that lack physical substance, are intangible assets.
Liquidity
On the balance sheet, assets are organized into two categories: current and non-current. Current assets include cash and those assets that are expected to be converted into cash
or consumed within 12 months of the balance sheet date. Non-current assets are assets that are expected to provide economic benefits for periods longer than a year.
The first current asset on Global Grocer's September 30, 2014, balance sheet is cash. It is followed by three other assets whose economic benefits turn into cash or are expected to
expire during the 12 months following the balance sheet date. They are accounts receivable (money owed to Global Grocer by customers), merchandise inventory (goods available
for sale) and prepaid expenses (rent paid in advance for the store).
The end of September balance sheet also includes several non-current assets: land, a warehouse, some store fixtures for display purposes, and a franchise fee asset. These assets
are expected to provide economic benefits for more than one year from the balance sheet date. Some tangible, non-current assets with limited lives, such as the warehouse
building, have an associated contra-asset account, called accumulated depreciation, that reduces the recorded value of the asset.
In the U.S., assets are reported in a standard order on the balance sheet. Current assets are listed first, starting with cash, and following in order of liquidity i.e., availability to
meet current obligations. For example, cash is more readily available than accounts receivable to pay creditor claims. Prepaid expenses, the last item listed as a current asset, is
probably not available at all. Non-current assets are listed next, typically starting with land, plant and equipment, followed by intangible assets, such as the franchise fee.
Exercise 3.2
Consider each item listed in the left column of the table below. Use the drop down menus provided to indicate whether the item meets each of the four asset criteria. Items that meet
all four criteria are assets.
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Exercise 3.3
Which one of the following best describes an asset that is expected to provide economic benefits for three years and does not have physical substance?
Liabilities
Now we shift our attention to the right side of the balance sheet, starting with liabilities. A liability represents an obligation of the entity to other parties. To be recorded as a liability, an
obligation must meet three requirements:
It involves a probable future sacrifice of economic resources by the entity

The economic resource transfer is to another entity
The future sacrifice is a present obligation, arising from a past transaction or event
Examples
Consider three liabilities that you will record on Global Grocer's August 31, 2014, balance sheet (not shown). Each satisfies all three criteria for being a liability.
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Not Liabilities
Here are some items that you will not record as liabilities on Global Grocer's balance sheet. Each fails to satisfy at least one of the three criteria for being recorded as a liability.
Liability Types
Liabilities are organized into two categories: current and non-current. Current liabilities are obligations that are expected to become due within 12 months of the balance sheet date.
Non-current liabilities are obligations that are expected to become due more than 12 months past the balance sheet date.
There are three current liabilities on Global Grocer's September 30, 2014, balance sheet: accounts payable (money owed by Global Grocer to its suppliers who will be paid during the
coming year), taxes payable (money potentially owed to the tax authorities) and a short-term debt (a loan to Global Grocer that it must pay back within a year of the balance sheet
date).
Global Grocer has one non-current liability on its September 30, 2014, balance sheet: a mortgage payable. The mortgage is a long-term loan. It represents money owed by Global
Grocer to a bank, with payments to be made for more than 12 months from the balance sheet date.
Exercise 3.4
Consider the items listed in the left column of the table below. Use the drop down menus provided to indicate whether the item meets each of the three liability criteria. Items meeting
all three criteria are liabilities.
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Owners' Equity
Owners' Equity is the residual interest of the entity's owners in the company's assets. It is the amount remaining after liabilities are deducted from assets.
Exercise 3.5
On June 30, 2014, Ardel company has total assets of $12,500,000. It has total liabilities of $10,500,000. What is the amount of Ardel's owners' equity on June 30, 2014?
The Accounting Equation

A simple relationship connects assets, liabilities and owners' equity. The key feature of a balance sheet is that total assets is always equal to total liabilities plus owners' equity. This
relationship between assets and liabilities plus owners' equity is known as the fundamental accounting equation.
The left side of the accounting equation--total assets--represents all of an entity's resources that have probable future economic benefits that the entity has obtained or controls as a
result of past transactions or events. The right side of the equation--total liabilities plus owners' equity--represents the sources for those resources. Therefore, the two sides must be
equal at all times.
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Exercise 3.6
Which one of the following best describes the fundamental accounting equation?
Concepts
In this section, we will introduce two more accounting concepts, namely the dual-aspect and historical cost concepts. They are particularly relevant to the balance sheet. These two
concepts provide guidance on the valuation of assets, liabilities and owners' equity.
Dual Aspect
The dual-aspect concept formalizes the idea that there are two sides to every accounting transaction. Recording both sides of each transaction is known as double-entry
bookkeeping.
The dual-aspect concept has a very important implication: after both sides of each accounting transaction are recorded on the entity's books, the basic accounting equation should
remain balanced.
Exercise 3.7
The dual-aspect concept tells us that
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Historical Cost
The historical cost concept, also known as the cost concept, provides guidance as to the amount at which a transaction should be reported initially in the entity's accounts. It
requires that transactions be recorded in terms of their actual price or cost at the time the transaction occurred.
Global Grocer is planning to buy a warehouse property. The historical cost concept directs you to record the warehouse property at its acquisition cost of $70,000. Others may think
the warehouse property is worth more or less than the amount Global Grocer paid, but their views are irrelevant. The accounting records will record the warehouse transaction
initially at the amount actually paid for it.
Relevance/Reliability
The historical cost concept provides a degree of reliability in the entity's accounts. It allows the accountant to ignore opinion and hearsay about the monetary value of items, and to
report amounts based on actual transactions. But, the use of the historical cost concept also means that some amounts on an entity's balance sheet are based on historical values,
determined at the time of purchase, which could predate the current balance sheet date by years. Consequently, it is unlikely that the asset amounts on the balance sheet reflect the
value that the assets would fetch if they were sold today. In this sense, the financial statements may be 'less relevant' for the purposes of users of the entity's balance sheets, than if
current market prices were reported.
As noted earlier, when relevance and reliability have to be traded off, financial reporting practice tends to favor reliability. Hence reliance on the historical cost concept may
sometimes yield more reliable but less relevant financial information.
However, accountants are not blind to the relevance issue. As you will learn in more advanced accounting classes, many monetary assets are recorded initially at their cost, and
subsequently measured and reported in the balance sheet at their market value. Monetary assets are items such as marketable securities. Their market value can generally be
estimated reasonably reliably. In addition, you will learn how accountants enhance relevance by recording some transactions to reflect their substance rather than their form.
While IFRS favors the historical cost model, it does present as an acceptable alternative treatment the revaluation of land and buildings to their market value, if their value can be
measured reliably subsequent to their initial recognition at cost.
Exercise 3.8
Sun Electronics purchases a stamping machine for $10,000. Almost immediately, a trade embargo restricts the number of stamping machines that can be imported into the U.S.
Based on want ads in the commercial section of the newspaper, stamping machines like Sun's are now selling for $15,000. Sun Electronics should immediately
Exercise 3.9
To users of an entity's financial statements, which of the following is a potential limitation of the historical cost concept?
Review
The exercises in this section cover all the material you have learned about the balance sheet up to this point. Take a few moments to test your understanding of this material.
Exercise 3.10
Choose the pair of words that best completes the fundamental accounting equation: _________________ = Liabilities + ________________
Exercise 3.11
Which one of the following is not a requirement for an item to be an asset?
Exercise 3.12
Global Grocer has purchased a warehouse building with an expected useful life of 10 years for $40,000. Which of the following is the best description of this new asset?
Exercise 3.13
A liability on the balance sheet represents _________________ of the entity.
Exercise 3.14
On January 1, 2014, Scott Manufacturing has assets of $1,600,000 and liabilities of $900,000. Its owners' equity is_______.
Let's Get Global Grocer Started

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You have spent much of August raising financing and making the necessary investments and pre-operating decisions to get Global Grocer ready to open its doors on September 1.
Although the transactions took place during August, for simplicity, you will record them all together on August 31st before the store opens. Of course, you start with an empty balance
sheet.
Common Stock
Short-Term Debt
Franchise Fee
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Prepaid Rent
Warehouse Property
Mortgage
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Store Fixtures
Merchandise Inventory
Hiring
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Exercise 3.15
Suppose Barnum and Sons obtains a 5-year $100,000 bank loan, payable at maturity. Which one of the following describes the effect of this transaction on its balance sheet?
Transaction Exercises
The exercises in this section describe various transactions and ask you how they affect the balance sheet. Take a few moments to test your understanding of this material.
Exercise 3.16
Exercise 3.17
On June 2, 2014, Mansfield purchases a computer system for $22,000 from Infostore Systems. Mansfield pays $10,000 in cash and promises to pay Infostore the rest in equal
installments over the rest of the year. The computer system is expected to last four years. Which of the following would you do in this situation?
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Exercise 3.18
Exercise 3.19
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Ratios
Users of financial statements use a technique known as financial ratio analysis to assess the financial position and performance of an entity. Financial ratios are ratios based on the
amounts in the financial statements. Two simple balance-sheet-based ratios are introduced in this section. They are the current ratio and the long-term-debt-to-equity ratio.
Current Ratio
An entity's ability to meet its current obligations - those due within the coming year - is an important measure of its financial health. These short-term obligations are usually
repaid in the normal course of business, as the entity's current assets are converted to cash. For example, cash is generated when merchandise inventory is sold for cash, or when
accounts receivables are collected in cash from customers. This cash can then be used to pay accounts payable.
The current ratio, or ratio of current assets to current liabilities, is a measure of an entity's ability to meet its maturing short-term obligations.
In the current ratio, the numerator, current assets, represents the resources of the entity that are either cash or expected to soon be converted into cash. Cash and these asset
conversions to cash can be used to satisfy the immediate claims of short-term creditors. The denominator, current liabilities, represents the current claims of creditors that must
be extinguished in the near-term.
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Current Ratio = Current Assets

Current Liabilities
Interpretation
While there is no single ideal current ratio, financial statement users often employ the rule-of-thumb that a healthy business will have a minimum current ratio of 2. Because
the appropriate current ratio varies by industries, financial statement users tend to focus on an entity's current ratio relative to those of other, similar businesses. In the U.S.,
the pharmaceutical industry has had an average current ratio of 1.8 over the past decade; the software industry, on the other hand, has had a 2.9 average current ratio over the
same time period. Software companies, with their limited need for fixed assets, traditionally hold a much larger proportion of their assets in cash and monetary current assets,
and this is reflected in their significantly higher current ratios.
If financial statement users notice that an entity has a current ratio that is significantly higher than that of its peers, they may be concerned that the entity holds more cash or
inventory than a business needs. This may signal that it is locking up potentially productive capital. If, on the other hand, an entity has current ratio that is significantly lower
than that of its peers, financial statement users may question its ability to satisfy its current obligations in a timely manner.
Exercise 3.20
Farrah Company's December 31, 2014, balance sheet shows current assets of $250,000 and current liabilities of $100,000. Its current ratio is _______.
Total Debt to Equity Ratio

The composition of a company's long-term capital structure - primarily its total interest-bearing debt and owners' equity - is of interest to financial statement users seeking to
assess the long-term financial viability of an entity. Of particular interest is the ratio of total debt (capital that accrues interest and has to be repaid to lenders) to equity capital
(capital that does not demand interest and does not have to be repaid).
The total debt to equity ratio is useful for judging an entity's long-term financial viability. As the name suggests, it is the ratio of all interest bearing debt on the balance sheet to
total equity. This ratio measures financial leverage or the degree of the entity's indebtedness relative to its equity funding.
Debt and equity are very different kinds of capital. When an entity assumes debt, i.e., accepts a loan, it has to pay interest and also repay the loan to the debt holder over an
agreed-upon period of time. If the entity runs into hard times and fails to pay its maturing financial obligations to its debt holders, they can force the entity into bankruptcy.
Equity capital, on the other hand, is a residual claim on the entity's assets. If a company becomes insolvent, equity holders get what remains after debt-holders have been
satisfied.
So, the larger the size of an entity's debt obligations relative to equity, i.e., the larger its total debt to equity ratio, the greater is the implied strain on the entity to make regular
payments to debt holders, and the higher is the risk of bankruptcy.
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Total Debt to Equity Ratio = Total Debt
Total Equity
Interpretation
There is no single ideal total debt to equity ratio. Over the past couple of decades, in the U.S., the average total debt to equity ratio for public companies has ranged from 0.5 to
1.0. However, it can vary considerably from one industry to another. Businesses in stable industries with tangible assets that make good collateral tend to borrow heavily to
finance those investments, so they tend to have high total debt to equity ratios. In contrast, volatile businesses with few tangible assets tend to have low total debt to equity
ratios. In the U.S., the software industry, which traditionally holds very little debt, has had a 0.10 average total debt to equity ratio over the past decade. On the other hand,
financial firms, which traditionally are very highly leveraged, have had a total debt to equity ratio of 3.3 over the same time period.
If a company has a total debt to equity ratio that is significantly higher than that of its peers, financial statement users may be concerned about its ability to make the required
payments to its debt holders and the company's long-term solvency may be questioned.
If, on the other hand, a company has a total debt to equity ratio that is significantly lower than that of its peers, financial statement users may question whether the company is
being aggressive enough in pursuing profitable growth opportunities by raising debt when necessary to finance those opportunities.
As with other financial ratios, there is no single perfect total debt to equity ratio for any business. What is important is a company's total debt to equity ratio relative to those of
other, similar businesses, and also how the ratio changes over time.
Exercise 3.21
Which one of the following choices best completes this sentence: The total debt to equity ratio is useful for judging ___________________.
Ratio Exercises
The exercises in this section test your understanding of the two simple balance sheet-based ratios: current ratio and total debt to equity ratio. Please take a moment to complete
these exercises.
Exercise 3.22
Exercise 3.23
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Recap
In this chapter, you learned the following:
How a balance sheet is organized.

Assets, liabilities and owners' equity were defined.
The key relationship linking assets, liabilities and owners' equity - the fundamental accounting equation - was explained.
The dual aspect and historical cost concepts were introduced and used to record all of Global Grocer's business transactions in August.
How to compute and use two simple but important balance sheet ratios - the current ratio and the total debt to equity ratio.
The Income Statement

In this chapter, you will learn more about the income statement and how it is organized. You will also be introduced to three new accounting concepts--the realization, matching and
conservatism concepts--as well as how to apply them to record the results of Global Grocer's business operations during the month of September. Finally, you will learn about two
ratios that are important measures of operating performance: the gross margin and return on sales percentages.
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Layout
In this section, you will learn how the income statement is organized. An income statement is a financial description of an entity's operating performance during an accounting
period. It reports the entity's sales, expenses and net income or loss for the period. The income statement's basic equation is Sales minus Expenses equals Net Income.
Here is a sample income statement for Global Grocer for its first accounting period, the month of September.
(1) The income statement heading lists the name of the entity, Global Grocer.
(2)The next line indicates the accounting period covered by the income statement; in this case, the month of September 2004.
(3) Sales are increases in assets or decreases in liabilities during a period resulting from delivering goods, rendering services or other activities constituting the entity's central
operations.
(4) From sales, we subtract the expenses associated with generating the sales of the period. Expenses are decreases in assets or increases in liabilities during a period resulting from
a delivery of goods, rendering of services, or other activities constituting the entity's central operations.
Gross Margin
The first segment of the income statement shows the company's sales, the cost of those sales and the difference, which is known as gross margin.
We calculated gross margin by subtracting from sales the cost of goods sold ("COGS"). Next we subtract the entity's other expenses of running the business to determine net
income.
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(1) From Sales, we subtract the cost of the goods sold during the accounting period.
(2) The excess of the sales amount over the cost of goods sold amount—or, sales minus cost of goods sold—is referred to as the gross margin or gross profit. It is called gross profit
because operating expenses have not yet been accounted for.
The first segment of the income statement shows the company's sales, the cost of those sales and the difference, which is known as gross margin.
We calculated gross margin by subtracting from sales the cost of goods sold ("COGS"). Next we subtract the entity's other expenses of running the business to determine net
income.
Other Line Items

You will notice on Global Grocer's income statement that the expenses of running the business listed below the gross margin are displayed in three categories: operating expenses,
interest expense and income tax expense.
(1) For Global Grocer, expenses listed below the gross margin are operating expenses, interest expense and income tax expense.
(2) Operating expenses, as their name implies, relate to the operations of the business. These include the marketing, selling and administrative expenses incurred in running a
business. They are often reported as a single account, selling, general and administrative (SG&A) expenses.
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(3) Gross margin minus operating expenses yields operating income (also known as operating profit). It is a measure of the profit generated from the day-to-day running of the
business.
(4) Interest expense is the cost of debt financing for the accounting period. If Global Grocer had invested any excess cash during this accounting period, interest income, if any,
would be reported in this section of the income statement. Operating profit minus interest expense yields income before income taxes.
(5) Income before income taxes minus the tax expense yields net income. Since taxes will not be due until next year, the tax expense is an estimate of the taxes that might have to
be paid on the profit when Global Grocer's 2004 tax return is filed.
(6) The net income for a period, i.e., the earnings of the entity, net of all expenses, is often called profit or net profit when it is positive (i.e., sales have been greater than total
expenses), or loss or net loss when it is negative (i.e., sales have been less than total expenses).
Link to Balance Sheet

The balance sheets at the beginning and end of an accounting period are linked, by the income statement for the period, through the retained earnings account in the owners' equity
section of the balance sheets.
Retained Earnings
The retained earnings account is the sum of the company's net income to date, less dividends, if any, paid to the owners. The net income for the period is added to the retained
earnings amount reported on the period's beginning balance sheet to determine the period's ending retained earnings, before any dividend payments.
Dividends
Dividends are distributions of earnings to owners, usually in the form of cash. The payment of a dividend reduces the Retained Earnings account.
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Summary
In summary, two events change the retained earnings account during an accounting period. First, the Net Income (loss) earned by the entity during the period increases
(decreases) the retained earnings account. Second, any dividends paid (distributions made to investors) during the period reduce the retained earnings account.
The payment of dividends is not an expense; it is a distribution of equity capital to investors. Hence, the payment of dividends is not recorded on the income statement; instead, it
directly reduces the retained earnings account.
Exercise 4.1
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During the month of April 2015, Mansfield Company records sales of $5,000, and total expenses of $3,000. What is Mansfield's net income for April 2015?
Exercise 4.2
Suppose Mansfield has a retained earnings balance of $20,000 on April 1, 2015. During the month of April, it earns a net income of $2,000 and also pays a dividend of $500 to its
investors. What is its retained earnings balance at the end of April 2015?
Concepts
In this section, we will introduce three more accounting concepts: the realization, matching and conservatism concepts. They are particularly relevant to the income statement.
These three concepts provide guidance as to the timing of the recognition and amounts of sales and expenses to be recorded by the entity. Like the other financial reporting
concepts, when properly applied, they reflect a balance between relevance and reliability in the reported amounts.
Realization Concept
Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable.
Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that
the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the
merchandise.
Realization is the process of converting assets, such as merchandise for sale, into cash, cash equivalents, or good accounts receivable.
Realization plays an important role in determining when revenue is recognized. Two conditions must be satisfied. First, the revenue must be earned, which typically means that
the customer has received the good or service. Second, the revenue must have been realized or realizable, implying that the customer has paid or is expected to pay for the
merchandise.
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IFRS
The IFRS and GAAP revenue recognition rules differ in their wording and underlying theory. IFRS recognizes revenue when the "risks and rewards of ownership are
transferred." In contrast, GAAP, among other requirements, recognizes revenue when it is "earned." Despite these differences, in most cases the accounting for revenue
transactions will be the same under either concept.
IFRS recognizes revenue when all the following conditions have been satisfied:
The seller has transferred to the buyer the significant risks and rewards of ownership of the goods;
The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the good sold;
The amount of revenue can be measured reliably;
It is probable that the economic benefits associated with the transaction will flow to the seller; and
The costs incurred or to be incurred in respect of the transaction can be measured reliably.
Exercise 4.3
Following GAAP, consider each situation described below and indicate whether revenue has been earned and whether it is realized or realizable by choosing the appropriate
entries in each cell.
Matching Concept
The GAAP and IFRS revenue recognition criteria tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is
recorded.
The timing of expense recognition is important since revenue less expenses equals net income. The Matching concept stipulates that expenses should be recognized in the same
period as the relevant revenues are recognized. Costs related to this period's activities but which are not directly related to products and services sold, are expensed this period.
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The Realization concept tells us when to recognize revenue. The Matching concept indicates what expenses should be recognized when revenue is recorded.
The timing of expense recognition is important since revenue less expenses equals net income. The Matching concept states that expenses should be recognized in the same
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Conservatism Concept
The Realization Concept and its associated "earned" requirements provide guidance as to when to recognize revenues and the Matching Concept provides guidance as to when to
recognize expenses. The Conservatism Concept goes one step further by recommending that prudence be exercised in recording revenues and expenses. It says that revenues
should be recognized only when reasonably certain, but expenses should be recognized as soon as reasonably possible.
Conservatism in financial accounting means that an entity should recognize only those revenues for which there is a high degree of confidence that they will be earned and
realized.
Expenses, on the other hand, should be recorded as soon as they seem likely to be incurred. If the entity is uncertain whether to recognize an expense or about the amount of an
expense, the conservatism concept encourages it to pro-actively estimate the cost and record the expense.
The conservatism concept also applies to the balance sheet. It suggests prudence in the recording of assets (record when reasonably certain) and in the recording of liabilities
(record as soon as reasonably possible). Further, if two different estimates of a balance sheet amount were equally acceptable, the conservatism concept would guide accountant
to record the smaller amount when measuring assets and the larger amount for liabilities.
Care must be taken when applying the conservatism concept. Otherwise, it can lead to bias in financial statements by understating profits in one period only to be followed by
overstatement in a subsequent period.
Let's Get Going

It is September 1 and this is Global Grocer's balance sheet. During August, you raised capital for Global Grocer, paid a franchise fee, bought store fixtures, purchased a warehouse
property, rented a store and stocked up merchandise inventory. You also hired two experienced employees who will start work today.
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(1) The current asset, accounts receivable, and the owners' equity account retained earnings, which have zero balances at present, will be affected by the operations that commence
today.
The First Few Sales

The store opens on Wednesday, September 1, and as expected, the first few days of store operations are slow. Several people stop by to browse, pick up brochures and taste the
free samples. The store makes three sales by the end of its first day of operations.
The dollar amount of each sale, the cash received, credit provided to customers and recorded as accounts receivable and the cost to Global Grocer of the goods sold (COGS) are
shown in this table. In each of these sales, goods have been delivered to the customer and cash has either been collected or is expected be collected by Global Grocer. The revenues
have been earned and are realized or realizable. The revenue recognition concept requires that you record the revenue from these first-day sales.
Recording
Sales and expenses are income statement accounts. However, they also affect the balance sheet, in particular, the retained earnings account. In order to build on our
understanding of the fundamental accounting equation (Assets = Liabilities + Owners' Equity), we will illustrate the impact of these first-day sales on Global Grocer's balance
sheet, and also begin to construct its income statement for September 2014. At the end of the accounting period, the month of September, we will complete Global Grocer's
income statement.
Cash Sale
Let's record the sale of the gift basket, where the customer paid the entire amount in cash.
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Credit Sale
Let's record the sale of the Italian pesto, where the customer put the entire amount on credit.
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Exercise 4.4
Record the effect of the third and final sale of the week: 100 pounds of Colombian coffee are sold for $400. The customer paid $150 in cash and put $250 on a credit account
with Global Grocer. Which one of the following choices correctly describes the effect on balance sheet of the revenue recognized from this sale?
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Now record the matched COGS expense related to the sale of 100 pounds of Colombian coffee. Global Grocer paid $2.60 per pound for the coffee in its inventory. Which one of
the following choices correctly describes the effect on balance sheet of the COGS expense recorded for this sale?
Balance Sheet Effect

The effect on the balance sheet of this profitable sale of 100 pounds of Colombian coffee for cash and credit is shown here. The cash account increased by $150, accounts
receivable increased by $250, merchandise inventory declined by $260 and retained earnings increased by $140. The fundamental accounting equation remains in balance.
Overall Effect
The three sales on the first day result in revenues of $1,000 (gift basket, $100 + pesto, $500 + coffee, $400) and related cumulative COGS of $600 (gift basket, $40 + pesto,
$300 + coffee, $260). $250 of the sales revenue was collected in cash and $750 was recorded as a receivable. Inventory was reduced by $600. These transactions resulted in a
$400 increase in retained earnings.
On the partial income statement we are constructing, we record the cumulative sales so far of $1,000 and COGS of $600. The gross margin earned so far is $400, exactly equal
to the increase in retained earnings due to these profitable sales.
Let's Tally Sept. Operations

Over the rest of September, as Global Grocer's reputation spreads, sales pick up. During the first accounting period, September 1 through September 30, sales totaled $16,000
(including the three first-day sales), of which $11,000 was collected in cash and $5,000 was put on account. Cost of goods sold amounted to $7,500. Customers did not make any
payments towards their credit accounts, and no inventory was purchased.
You have tracked and recorded sales and COGS, and calculated gross margin for the month of September. It is time to record the other expenses of the accounting period.
Expenses of the Period

You will now record the operating, interest and tax expenses for the period. These are costs that are not associated with future revenues, so we will match them to the revenue
recognized for the month.
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Salaries
First, we record the salaries expense related to employee salaries. You and the two employees each were paid $1,000 in cash for the month's work, for a total monthly salary
expense of $3,000. This transaction increases the operating expenses on the income statement by $3,000. Like all expenses, this expense reduces retained earnings on the
balance sheet. The salaries were paid in cash, so the cash account also decreases by $3,000.
Utilities
The utilities expense for the month was $500, also paid in cash.
Rent Expense
Store rent is $1,000 per month. Global Grocer had already prepaid three months' rent, reflected in the prepaid expenses balance of $3,000 on the August 31 balance sheet.
Recognition of the rent expense of $1,000 for the month of September requires an equal reduction in the prepaid expenses asset account. Take special note of this transaction:
no cash is exchanged at this point, but the rent expense associated with the passage of the month is recorded. This is accrual accounting.
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Depreciation
The next operating expenses we will record are associated with the use of tangible non-current assets — the warehouse building and store fixtures. Global Grocer acquired these
assets with the expectation that they would provide economic benefits for a number of years. The matching concept requires that the cost of each of these assets be spread over
its useful life, and in each accounting period an expense be recorded to reflect the reduction in the useful life of the asset. This expense is called Depreciation Expense.
Depreciation of a tangible long-lived asset also reduces the balance sheet value of the asset. This is accomplished using an accumulated depreciation account, a counterpart
to the asset account, but with the opposite sign. Its net effect is a reduction in the recorded value of an asset. An asset's historical cost (its depreciable purchase price) minus its
accumulated depreciation yields its net book value. The net book value of each long-lived asset is used to compute total assets on the balance sheet.
Net Book Value = Historical Cost - Accumulated Depreciation
Warehouse
We estimate that the warehouse depreciation expense for each month of its use is $300. The contra-asset — or negative asset — account, accumulated depreciation on
the warehouse building, is increased by $300, and the depreciation expense reduces retained earnings by the same amount. In effect, the $300 increase in the accumulated
depreciation contra-asset account decreases total assets by $300, and the fundamental accounting equation is maintained.
On the September 30 balance sheet, the warehouse building will have a net book value of $39,700, and this amount will be included in the calculation of Global Grocer's total
assets at the end of September.
Net Book Value = Historical Cost - Accumulated Depreciation
= $40,000 - $300 = $39,700
Store Fixtures
Global Grocer has another long-lived depreciable tangible asset, store fixtures. It should also be depreciated to reflect its reduced expected useful life at the end of September.
One month's depreciation on the store fixtures is estimated at $100. This is how we record the $100 monthly depreciation expense related to the store fixtures.
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Land
Global Grocer has another long-lived, tangible asset: land. For financial reporting purposes, land is assumed to have an indefinite life. As a result, its useful life is assumed to
remain undiminished during the passage of an accounting period. Therefore, land is never depreciated. Until it is sold, the land will remain on Global Grocer's balance sheet
at its historical cost of $30,000.
Exercise 4.5
The store fixtures were purchased for $5,000 at the end of August. At the end of September, the related accumulated depreciation on that asset is $100. What is the net book
value of the store fixtures asset on the September 30 balance sheet?
Amortization
For an intangible long-lived asset, we record a reduction in its remaining useful life by recording an amortization expense that directly reduces the value of the asset on the
balance sheet. Note that amortization and depreciation expenses both reflect the diminishing useful lives of assets. However, the effect of each is recorded differently on the
balance sheet. Depreciation expense is recorded for each depreciable tangible asset and it accumulates in a related contra-asset account on the balance sheet. Amortization
expense is recorded for each amortizable intangible asset, and there is no associated contra-asset account: amortization expense directly reduces the related intangible asset
account on the balance sheet.
Franchise Fee
The franchise fee is a long-lived, intangible asset. It will benefit the store for two years, at the end of which it will expire. The September amortization expense on the
franchise fee is estimated to be $750.
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Operating Expenses
Let's gather up all of Global Grocer's operating expenses for the month of September. The salaries, utilities, rent, depreciation and amortization expense totaled $5,650. With
sales of $16,000, COGS of $7,500 and operating expenses of $5,650, Global Grocer's September operating income is $2,850.
Debt Service
Let's now record Global Grocer's interest expense for September. The debt on Global Grocer's balance sheet involves a contractual obligation to pay interest. Global Grocer has
two outstanding debt obligations.
Short-Term Interest
First, let's record the interest expense on the $50,000 short-term debt, and the payment made to the lender. For this loan, Global Grocer will record a September interest
expense of $250 and a $250 reduction in the cash account.
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Mortgage Interest
Global Grocer's mortgage is a long-term loan with the warehouse building as collateral. The cash payment of $250 covers the $150 interest for September and reduces the
loan principal by $100. First, record the September interest expense of $150 on this loan, paid in cash to Webster Bank.
Mortgage Principal
We also have to record the payment of an additional $100 in cash this month to account for the reduction in the outstanding mortgage loan principal. This transaction has no
effect on the income statement. It reduces cash and the mortgage payable account by $100 each.
Interest Expense
Global Grocer's total interest expense for the month of September is $400: $250 interest expense on the short-term loan, and $150 interest expense on the mortgage.
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Tax Expense
To complete Global Grocer's September income statement, you must record its income tax expense for the month. You estimate that this period, Global Grocer will owe $950
(reflecting a tax rate of 38%) of its income before income taxes to the tax authorities. Therefore, it records a tax expense of $950 for the month of September.
Congratulations!
Congratulations! You have completed Global Grocer's income statement for the month of September. Global Grocer earned a net income of $1,500 during its first month of
operations.
Preparing for the future

As September progresses, you assess Global Grocer's financial situation and prepare for the upcoming holiday season. Apart from the operations whose effect has just been recorded
on Global Grocer's September income statement, you also undertake some activities that do not affect this month's net income statement.
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Exercise 4.6
On September 28, your parents, thrilled at Global Grocer's early success, invest $30,000 in the business and in return receive common stock. How will this transaction affect
Global Grocer's financial condition?
Exercise 4.7
Business is picking up at Global Grocer, and you need a van for the growing volume of purchases and deliveries. On September 10, you purchase a second-hand van. It is then
repaired and painted with the Global Grocer logo. It is delivered to you on September 30. The total cost is $10,000. You pay in cash on delivery of the van.
How does the purchase of the van on September 30 affect Global Grocer's September income statement?
Exercise 4.8
Global Grocer's merchandise stock has been getting seriously depleted during this successful first month. On September 20, you ordered $8,500 of inventory. It arrives on
September 30. You pay $2,500 cash and put the rest on a credit account with Global Grocer International. The effect of this transaction on September's income statement would
be
Exercise 4.9
As agreed, starting in October Global Grocer will have to pay Global Grocer International for inventory purchased in September on credit. Also, you will need to stock up for the
upcoming holiday season. All of this will use cash. Accordingly, you present Global Grocer's accounts to Webster Bank, and on September 30, obtain a $20,000 3-month short-
term loan, interest and principal to be paid at maturity.
Recall that Global Grocer has a monthly accounting period. Which one of the following will be the most appropriate accounting treatment of the interest expense on this new
loan?
End of Period
This is Global Grocer's September 30 balance sheet. It includes all the changes that occurred due to operations during the month of September. It also includes the investing and
financing activities you undertook to prepare for the holiday season and for future business expansion, insofar as those activities impact the September accounts.
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Ratios
Users of financial statements use a number of financial ratios based on income statement numbers. We will discuss two of the more important ones: gross margin as a percentage of
sales and return on sales percentage. Both ratios can help us evaluate a company's success at maintaining its chosen price/cost strategy.
Gross Margin Percentage

Gross margin as a percentage of sales is dollar gross margin divided by sales, expressed as a percentage. Dollar gross margin is sales minus cost of goods sold. It represents the
mark up on the cost of the products sold by a company.
By expressing dollar gross margin as a percentage of sales, we can compare the gross margin of a company at different points in time, or the gross margin percentages of different
companies in similar businesses. This type of analysis provides financial statement users useful insights into a company's pricing strategy and practices.
Comparison
For example, consider Company A with $100 million in sales and $60 million in COGS. Its dollar gross margin is $40 million, and its gross margin percentage is 40%. Now
consider Company B, in the same industry, with $200 million in sales and $140 million in COGS. B's dollar gross margin is $60 million, and its gross margin percentage is
30%.
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A company's gross margin percentage is influenced by its industry, its own pricing strategy, and the efficiency with which it produces its goods and services. A comparison of
Company A and Company B's gross margin percentages raises several questions: Why is there a difference between the gross margin percentages of two companies in the same
industry? Is Company A following a high-price strategy? Is Company B following a discounted-price strategy? Does it plan to sell a larger volume by discounting price to earn a
higher dollar gross margin? This type of analysis is particularly useful when a company's performance is compared against that of industry benchmarks or standards.
Interpretation
Over the past decade, U.S. software and pharmaceutical companies have averaged gross margin percentages of about 70%. In comparison, over the same period, gross margin
percentages in the U.S. automotive industry have averaged about 22%.
The high gross margin percentages in software and pharmaceuticals is partly explained by the fact that in these industries, research expenses, which represent a major share of
total expenses, are not included in the cost of goods sold. The actual cost of producing a software program on a disk in a software business or of producing tablets for patients at
a pharmaceutical company--the cost of goods sold--is extremely small, resulting in very large gross margins relative to sales. Also, patent protections can limit product
competition and result in higher prices. The cost of producing automobiles, on the other hand, is high relative to their selling price and the industry is very competitive. This
limits the ability of automobile companies to achieve high gross margin percentages.
Exercise 4.10
Return on Sales Percentage

Return on sales percentage is calculated as net income per dollar of sales, or net income divided by sales, expressed as a percentage.
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By expressing net income as a percentage of sales, i.e., by using return on sales, we can compare the performance of a company at different points in time, or the performances of
different companies in similar businesses. This type of analysis provides financial statement users useful insights into a company's pricing strategy and its ability to control costs.
Comparison
For example, Company P, with sales of $100 million, has a gross margin percentage of 50% and, with a net income of $20 million, a return on sales percentage of 20%.
Company Q, with sales of $200 million, also has a gross margin percentage of 50%, but, with a net income of $30, has a return on sales percentage of 15%.
A company's return on sales percentage depends on the nature of the industry the company is in, its own business strategy, and its efficiency in delivering its goods and
services. Because net income is affected by interest and tax expense, unlike the gross margin percentage, return on sales is affected by the company's capital structure and its
tax regime.
Interpretation
Over the past decade, return on sales percentages in the U.S. software industry have averaged about -4%, that is, negative four percent! Despite their extremely high gross
margin percentages, averaging about 70%, as a group, software companies have had negative return on sales.
During the same period, U.S. pharmaceutical companies have averaged return of sales of about 10%. The pharmaceutical industry, like the software industry, incurs high
research costs, but it has managed to convert its high gross margin percentages, also averaging about 70%, into high returns on sales percentages. For comparison purposes,
return on sales percentages have averaged about 3% in the automotive industry during the same time period.
Exercise 4.11
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Recap
In this chapter, you learned
how an income statement is organized and constructed.

sales and different categories of expenses are defined and the relationship between the income statement for a period and the balance sheets at the beginning and end of the
period.
the revenue recognition, matching and conservatism concepts and how they are used to record the financial effects of Global Grocer's operations during the month of
September.
the definition and use of two important income statement ratios — the gross margin percentage and the return on sales percentage.
Accounting Records
In this chapter, you will learn a simple version of the steps by which accounting systems track and record financial accounting transactions during an accounting period. You will also
learn how to prepare a balance sheet and an income statement at the end of an accounting period. You understand the economic and accounting impact of Global Grocer's August and
September 2014 accounting transactions; in this chapter, you will record them in the journal and ledger which will be used to prepare the balance sheet and income statement for
those periods. At the end of the chapter, you will be able to practice what you have learned.
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Overview
In any accounting system, a series of systematic steps help the entity and its accountants track and record its financial activities during an accounting period and to prepare the
desired financial statements at the end of the period. This flow chart depicts a simple accounting system.
(1), (2) As transactions occur, each is analyzed to decide which accounts it affects and how. This step requires a knowledge of accounting concepts and judgment on the part of the
person recording the transaction. This is the analysis we performed in earlier chapters to record increases and decreases in various accounts each time Global Grocer completed a
transaction.
(3) Next, the transaction is recorded in a journal. A journal is a chronological record of the entity's transactions as they occur. Note that once the transaction analysis has been done,
making a journal entry, or journalizing the transaction, is a purely mechanical step.
(4) After the journal entry is made, the transaction is recorded—or posted to—the ledger. Posting the entry into the ledger, too, is a mechanical step. The ledger is a grouping of
transaction information by account. Accounts in the ledger are classified as either balance sheet accounts (for example, the cash account) or income statement accounts (for
example, the sales account).
(5) The accounting entries we have made to date are called original entries. They were initiated by transactions with internal and external parties. At the end of the accounting
period another kind of entry—adjusting entries—must be recorded so that the account balances reflect fairly the situation at the end of the period. These transactions do not involve
internal and external parties. For example, an entry must be made to reflect a depreciation expense for the period due to the passage of time.
(6) At the end of the accounting period, after all of the original and adjusting entries have been entered in the journal and posted to the ledger, the various ledger accounts will show
a balance. The balance sheet account balances are carried forward to the next period. The income statement (temporary accounts) are closed and reset to zero by transferring (in our
simple system) their balances to retained earnings.
(7) After the closing process, the balances in the permanent accounts provide the information needed to prepare the balance sheet at the end of the accounting period. The income
statement (temporary) account closing entries provide the information needed to prepare the income statement for the period. (Other financial statements, beyond the scope of this
chapter, can also be prepared at this point).
Double-Entry Accounting
Recall the dual aspect concept: there are two sides to every financial transaction. A double-entry accounting system records the dual effects of each financial transaction. Each
transaction affects at least two accounts.
Consider a transaction you have already encountered: raising $80,000 cash by issuing common stock, Global Grocer's first transaction. Global Grocer recieved cash and issued
common stock. Account analysis indicates that two accounts were affected by this transaction: the cash account and the common stock account. The financial accounting system, a
double-entry system, recorded an increase of $80,000 in the cash account and an increase of $80,000 in the common stock account. This is how we recorded the transaction when
it occurred.
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Now you will learn to record the effect of such a transaction using the conventions of a financial accounting system.
Journal Entries
When a transaction occurs and has been analyzed, an entry has to be made in the journal. The journal is a chronological record of the entity's transactions.
Debits and Credits

Each change to an account consists of a dollar amount and a direction (whether it is an increase or a decrease). In accounting, we indicate the direction of the change by a
specialized use of the words debit and credit. While learning financial accounting, you should forget day-to-day meanings of the words debit and credit. You only need to
remember the accounting meaning of these terms.
So you see, debit and credit do not mean bad or good. Neither of them even means increase or decrease every time it is used. You will see what these terms do mean in accounting
when you learn to enter transaction data in the ledger.
(1) For asset accounts, increases are recorded as debits, decreases are recorded as credits.
(2) For liabilities and owners' equity accounts, decreases are recorded as debits, increases are recorded as credits.
(3) For the sales account, an increase (i.e, the recognition of revenue) is recorded as a credit, because, in fact, a sale is an increase in owners' equity. Sales can also decrease—for
example, when a sale is reversed, then sales of the period decrease, and the sales account is debited.
(4) For an expense account, an increase (i.e., the recording of an expense by the entity), is recorded as a debit, because, in fact, an expense is a decrease in owners' equity.
Expenses can also be reversed or reduced, and then, the appropriate expense accounts are credited.
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Exercise 5.1
This is a list of Global Grocer's transactions during the month of August, in preparation for its September 1 opening. Record a journal entry for each transaction. Note that for
convenience, all these transactions were recorded on Global Grocer's books on August 31.
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Ledger
After a journal entry has been made, it is posted to the ledger, which contains T-accounts, one for each account. Accountants use T-accounts as an aid to double-entry bookkeeping,
one that helps track changes (debits and credits) to different accounts, and when used correctly, ensures that the basic accounting equation holds after each transaction.
T-Accounts
Each T-account is associated with a single account, such as Cash, Accounts Payable, Common Stock or Sales. The T-account is literally a large 'T' with an account name on top. The
left side of the T-account is the debit side. The right side of the T-account is the credit side. So, in financial accounting, debit means left side, and credit means right side. Before you
proceed, you must memorize this fact.
At any given time, each account has a balance (the monetary amount in that account). An account may have a debit (left-side) or a credit (right-side) balance.
Putting it Together
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Combining the journal-related use of debit and credit with their ledger-related meanings, immediately tells us how to post journal entries to the ledger. For asset accounts,
increases are recorded on the debit side or the left side of the T-account. Decreases in asset accounts are recorded on the credit or the right side of the T-account.
For liability and owners' equity accounts, decreases are recorded on the debit or the left side of each T-account. Increases in liability and owners' equity accounts are recorded on the
credit or right side of the T-account.
Increases in sales are recorded as credits and increases in expenses are recorded as debits.
Combining the journal-related use of debit and credit with their ledger-related meanings, immediately tells us how to post journal entries to the ledger. For asset accounts, increases
are recorded on the debit side or the left side of the T-account. Decreases in asset accounts are recorded on the credit or the right side of the T-account.
For liability and owners' equity accounts, decreases are recorded on the debit or the left side of each T-account. Increases in liability and owners' equity accounts are recorded on the
credit or right side of the T-account.
Increases in sales are recorded as credits and increases in expenses are recorded as debits.
Post to Ledger
Press the 'Post to Ledger' button to post all of the August journal entries you have prepared for Global Grocer. You will see that each posting is labeled with the number of the
corresponding journal entry, making it easy to trace and check the debits and credits in each transaction.
August 31 Balance Sheet

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In August, Global Grocer had no operations. Its accounts were set up on August 31. On that date, there were no adjusting entries or closing entries to be made. The balance sheet
accounts in the ledger provide the information needed to prepare Global Grocer's balance sheet as of August 31.
September accounts
Global Grocer began operations on September 1, 2014. Let us formally track and record its financial transactions in September. We will essentially repeat the record-keeping we
performed in the income statement chapter; only, this time, instead of recording the effect of each transaction directly on to the balance sheet and the income statement, we will
record it in the journal using debits and credits, and post it to T-accounts in the ledger. At the end of the month, we will prepare adjusting entries and closing entries, post them to the
ledger and prepare the balance sheet and income statement for September.
First Sale
Recall that the store opened on Wednesday, September 1, and made three sales by the end of its first day of operations. The first sale of one gift basket for $100, is paid for in cash.
Global Grocer increased its asset cash by $100 and recognized revenue of $100. To record this transaction, debit cash and credit sales for $100 each. This is the journal to record the
revenue from the sale.
COGS Entry
The large gift basket had cost $40. Global Grocer decreased its asset merchandise inventory by $40 and recorded an equal cost of goods sold expense. This means a debit to cost of
goods sold expense and a credit to merchandise inventory of $40 each.
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Exercise 5.2
Now, you make the journal entries related to the next sale on September 1: the sale of 25 jars of Italian pesto. Be sure to record journal entries to recognize revenues and the
matched cost of goods sold.
Exercise 5.3
Repeat the previous exercise for the third sale on September 1: the sale of 100 pounds of Colombian coffee for cash and credit. Once again, be sure to record journal entries to
recognize revenues and the matched cost of goods sold.
Posting Sales to Ledger

Press the 'Post to Ledger' button to post the journal entries for the initial three sales into the ledger.
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Third Party Transactions

We fast-forward to September 30 and record the effect of all of Global Grocer's transactions with external entities. During September, Global Grocer recorded total sales of $16,000
of which $11,000 was collected in cash, and a total cost of goods sold expense of $7,500. Customers did not make any payments towards their credit accounts, and no inventory was
purchased. On September 30, monthly salary expense of $3,000 and utilities expense of $500 was fully paid in cash. In addition, loan service payments were made, and, you
undertook some preparations for the upcoming holiday season.
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Adjusting Entries
Recall that in accrual accounting, at the end of each accounting period, a number of adjusting entries have to be made. These transactions, which do not involve any external parties,
represent expenses that are not associated with either the goods or services sold during the period or with future revenues. They must therefore be recorded in the current period.
At the end of September, the first month of operations, there are several adjusting entries to be made. We can identify the accounts that need to be adjusted. They are prepaid
expenses, warehouse building, store fixtures, franchise fee and taxes payable. Take note that adjusting entries do not involve any economic exchange with a third party.
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Exercise 5.4
Closing Entries
Now it is time to close out each temporary or income statement account and reset it to a zero balance, in preparation for the next accounting period. Notice that the sales account has a
credit balance, and all the expense accounts have debit balances.
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Prepare the Balance Sheet

After closing out the income statement (temporary) accounts, the balances in the ledger's balance sheet (permanent) accounts are transferred to the balance sheet at the end of the
period.
Prepare the Income Statement

The closing entry shows the balances in all the income statement accounts just before they were closed, and hence provides the information needed to prepare the income statement of
the period.
Recap
In this chapter, you were introduced to a simple form of the formal book-keeping performed by any accounting system. You learned that:
In double-entry book-keeping, both sides of each transaction are recorded, and at least two accounts are affected.
After analyzing a transaction, a journal entry is prepared using the rule that debits indicate increases in assets and in expenses and credits indicate increases in liabilities,
owners' equity and sales.
Journal entries are posted into a ledger of T-accounts where 'debit' means left side of the T-account and 'credit' means right side of the T-account.
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Once all transactions with outside entities are recorded for the period, adjusting entries are made to particular accounts.
A closing entry is made to close or reset all sales and expense accounts to zero.
Finally, the balance sheet and income statement are prepared.
We applied these steps to Global Grocer's August and September transactions, and, by following the process, generated its balance sheets and income statement for two accounting
periods.
The Statement of Cash Flows

In this chapter, you will learn about the statement of cash flows, one of the three basic financial statements prepared and presented by an entity. It provides information about the
entity's sources and uses of cash during an accounting period.
The statement of cash flows can be presented in two different formats called the direct method and the indirect method. You will learn how to construct and use each type of statement
of cash flows for Global Grocer.
Direct Method
The direct method statement of cash flows for an accounting period summarizes the transactions that have been posted to the cash ledger account during the period. This information
is presented in three categories: operating, investing and financing activities. Here you see Global Grocer's direct method statement of cash flows for the month ending August 31,
2014. The indirect method statement of cash flows will be discussed later in this chapter.
(1) Operating activities are directly related to the delivery of goods and services that generate revenues and expenses in the income statement. The operating activities section shows
the cash flows from these activities. They are typically broken down into cash collected from customers, cash paid to suppliers, cash paid for other day-to-day operating costs and cash
taxes. In the U.S., GAAP requires that interest paid or received in cash during the period be included in the operating section of the statement of cash flows.
During August, Global Grocer used cash for two operating activities: it paid $8,000 to suppliers of merchandise and it prepaid $3,000 cash towards store rent. In total, $11,000 cash
was used for operating activities during August.
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(2) Investing activities relate to the purchase and sale of long-lived assets. In August, Global Grocer had three investing activities involving cash, all of which depleted the cash account
—the purchase of the warehouse property used $70,000 cash, the purchase of store fixtures used $5,000 cash and the payment of the franchise fee to Global Grocer International used
$18,000 cash. In total, investing activities used $93,000 in cash during August.
(3) The financing activities section shows the cash effects of raising or retiring debt, new issues or repurchases of equity, and the payment of any cash dividends. During August,
Global Grocer raised $80,000 cash from a common stock issue, raised $50,000 cash from a short-term bank loan and $25,000 cash from a mortgage. In total, financing activities
provided $155,000 cash during August.
As already noted, any interest paid to service outstanding loans is not recorded in this section—by GAAP, it is included in the operating section of the statement of cash flows.
Preparation
The direct method statement of cash flows is constructed at the end of an accounting period using the cash account in the ledger. Cash is an asset account. Each debit to cash during
the period is an increase in the entity's cash balance (a source of cash) and each credit is a decrease (a use of cash). We simply classify each debit and credit in the cash account as
either an operating, investing, or financing item and re-arrange them into these three categories to obtain the direct method statement of cash flows.
Exercise 6.1
This is Global Grocer's Cash T-account for the month of September. Each cash transaction is identified with a small description. For each transaction, indicate whether it is an
operating, investing, or financing transaction. When you have correctly classified each cash transaction, you will have prepared September's direct method statement of cash flows
for Global Grocer!
Indirect Method
The second format used to present the statement of cash flows is the indirect method. It is also organized by operating, financing, and investing activities. Here are two statements of
cash flows for Global Grocer for September; the one on the left is a direct method statement of cash flows and the one on the right is an indirect method statement of cash flows for the
same period. Both statements show that during the month, operating activities generated $4,600 in cash, investing activities used $10,000 in cash, and financing activities provided
$49,900 in cash.
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Differences
The two statements differ in only one area: the format and information included in the cash flows from operating activities section. The investing and financing cash flows sections
are exactly the same in both types of statements of cash flows.
Accruals and De-Accruals

Recall that accrual accounting records the economic effects of transactions in the period in which those transactions occur, rather than in the periods in which cash is received or
paid by the entity. Under accrual accounting, we record some accruals that have related cash flows in the future, and the resultant balance sheets and income statements reflect the
effects of those accruals rather than use future cash flows.
An Example
For example, on September 1, Global Grocer made a $400 sale of Colombian coffee, collected $150 in cash and recorded $250 as a receivable. The $250 increase in receivables was
an accrual. It will result in an inflow of $250 in cash in a future period, but the full $400 was recorded as a sale on September 1.
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If, on September 1, starting with the sales amount $400, we wish to calculate the cash effect of that transaction, we have to de-accrue, or reverse the $250 accounts receivable
related sales accrual to arrive at the $150 cash effect of the coffee sale, i.e., $400 minus $250 equals $150. In the indirect method statement of operating cash flows, each
adjustment to net income is the sum of one or more de-accruals for the period.
Why the indirect method?

Given the relative complexity of the operating section of an indirect method statement of cash flows, you might wonder why do accountants use them at all? Answer: Because the
operating section of the indirect method statement explains the difference between the net income and the operating cash flows of the period, it provides readers with information
about the extent to which and the means by which the entity's net income of the period has resulted in operating cash flows.
The Financial Accounting Standards Board requires entities that use the direct method in their statement of cash flows to present a separate reconciliation of net income to
operating cash flows using the indirect method. As a result, most companies choose to present only the indirect method statement of cash flows.
Exercise 6.2
The Huntington Company uses the direct and indirect method statements of cash flows. For the 10 cash flow items listed below, indicate the section that they would appear in on
the statements of cash flow listed:
A. Direct method; cash flow from operating activities section
B. Indirect method; cash flow operating activities section
C. Investing activities section
D. Financing activities section
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Barron & Sons' cash balance increased by $55,000 during 2014. During that year, it raised $23,000 cash from financing and used $12,000 cash for investing activites. What was
Barron & Sons' net cash from operating activites during 2014?
Net Income & Op. Cash Flows

Accrual accounting focuses on capturing the economic meaning of a transaction, rather than its cash effects. This usually results in a difference between a period's net income and the
operating cash flow to the entity, although both are the result of operations during the period. For example, in August, Global Grocer had a zero net income, but it had a negative
operating cash flow of $11,000.
This picture shows how the indirect method statement of cash flows reconciles the difference between a period's accrual accounting based net income and its cash flow from
operations.
(1) A de-accrual is an adjustment made to net income to arrive at the cash effect of operating activities. We will analyze examples of each type of de-accrual in turn.
(2) De-Accrual of Period's Depreciation/Amortization. A non-cash expense (i.e. neither the debit or credit side of the transaction involves cash).
(3) Sales-Related De-Accruals

The difference between sales and cash collected from customers during the period. In this case accounts receivable (an asset) increased during the period.
(4) COGS-Related De-Accruals

The difference between cost of goods sold expense and cash paid to suppliers. This adjustment is the net of two adjustments. Inventories (an asset) and accounts payable (a liability)
both increased.
(5) De-accruals related to current period expenses funded in prior periods. In this example prepaid expense (an asset) decreased.
(6) De-accruals related to current period expenses that will be paid in future periods. Other payables (a liability) increased.
(7) The difference between various expenses of the period (other than cost of goods sold) and cash paid to external parties such as suppliers, utilities providers, landlords, banks, and
tax authorities.
operations.
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operations.
operations.
operations.
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Recap the Indirect Method

You have just learned the reasoning behind each of these de-accruals in the indirect method statement of cash flows.
We start with net income of the period, add depreciation and amortization expense, add decreases (or subtract increases) in accounts receivable, add decreases (or subtract increases)
in inventory, add increases (or subtract decreases) in accounts payable, add decreases (or subtract increases) in pre-paid expenses, and add increases (or subtract decreases) in other
payables. This will give us net cash provided or used by operating activities during the period.
Take a good look at the adjustments to net income: they are themselves not cash flows. These are the sales and expense-related de-accruals made to reconcile the difference between
net income and cash flow from operations. These amounts are calculated from the change between the beginning and ending balances of particular current asset and current liability
accounts during the accounting period, excluding changes in the cash account and short-term debt (a financing item).
Relation to Balance Sheet

The indirect method statement of cash flows does not require any new accounts. In practice, the indirect method statement of cash flows for an accounting period is constructed using
the period's net income, the period's depreciation and amortization expenses, differences between the period's beginning and ending current asset and liabilities accounts, excluding
cash and short-term debt. Here is a schematic of the entire indirect method statement, indicating the sources of the various line item amounts.
Sept. Indirect Statement
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Exercise 6.3
Mansfield Company's comparative balance sheets for December 31, 2013, and December 31, 2014, show the changes listed in the table above. For each change, use the drop-down
menus to indicate the adjustment that must be made to its 2014 net income in the operating section of its indirect method statement of cash flows for the year ending December
31, 2014.
Interpretation
Net cash flow is a very important financial metric in any business. Users of financial statements want to know how much cash was generated or used by a business during an
accounting period and how it was generated or used. The inferences made by a reader from a statement of cash flows depend on the type of company the statement represents - what
industry it is in and the life-stage it is in. A start-up software company is expected to have a significantly different pattern of cash flows from those of a mature chemicals
manufacturer.
For a new business like Global Grocer, users of the entity's financial statements look for evidence that the business is raising sufficient cash to support the necessary investments and
ramp up of operations through the early periods of slow sales and collections from customers. The statement of cash flows can aid in this type of analysis. For example, Global Grocer's
August statement of cash flows shows that its August operations did not generate any cash (in fact, they consumed cash). All of its cash was generated from financing activities, and
about two-thirds of the cash raised was used up to set up the business. As Global Grocer starts up operations, improvements in its ability to satisfy its cash needs from operations will
be evaluated.
In the case of a more mature business, users of an entity's financial statements look for evidence that its operations are generating enough cash, and that it is using financing
prudently enough to support its growth, pay dividends, and invest in long-term, productive assets. The statement of cash flows can also aid in this type of analysis.
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Analysis of Indirect Statement

By organizing the information in a particular way, the indirect method statement of cash flows provides important information to users of an entity's financial statements that is not
available from a direct method statement of cash flows.
The operating section of the indirect method statement of cash flows explicitly provides the depreciation and amortization expenses for the period, information that would otherwise
be scattered in the balance sheet and embedded in various expense accounts on the income statement. It is expected that a mature company's capital expenditures - its cash payments
for non-current assets -- meet or exceed the depreciation expense of the period. This would indicate that the company is replacing long-lived assets at about the same or greater rate
than their economic benefits are being consumed.
Suppose a company has a significantly higher net income than net cash flow from operations in successive periods. This may be explained by the fact that the company is growing
rapidly, making sales on credit, and raising the necessary cash from financing activities. But, it could also indicate that the company, despite a healthy net income, is failing to collect
cash from its customers in a timely manner. These sorts of effects would be easily seen from the change in receivables in the operating section of the indirect method statement of cash
flow.
There are many different types of analyses that may be conducted with the information available in an indirect method statement of cash flow to assess the health of - or trends in the
health of - an entity. They are beyond the scope of this introductory tutorial.
Recap
In this chapter, you learned about the statement of cash flows, an important financial statement prepared by entities. You learned that:
The statement of cash flows classifies and organizes information about the cash flows during an accounting period as operating, investing or financing.
There are two formats for the statement of cash flows: the direct method and the indirect method. They differ in their presentation of operating cash flows.
Under the direct method, in the operating section, are included a number of line items, each of which is a cash inflow to the reporting entity or a cash outflow to an external
entity.
The operating section in the indirect method starts with the net income and make a series of de-accrual adjustments to it in order to derive the net cash from operations.
The direct method statement of operating cash flows can be prepared directly from the entries in the cash T-account during the accounting period.
The indirect method statement of operating cash flows is prepared from the period's income statement accounts and the period's beginning and ending balance sheets.
Final Exam 1 Introduction

Welcome to the post-assessment test for the HBS Financial Accounting Tutorial. This test will allow you to assess your knowledge of financial accounting fundamentals.
Navigation:
Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a
question, you must navigate back to it and answer it - all questions must be answered for the exam to be scored.
Good Luck!

Welcome to the second post-assessment test for the HBS Financial Accounting Tutorial. This test will allow you to assess your knowledge of financial accounting fundamentals.
Navigation:
Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although you can skip a
question, you must navigate back to it and answer it - all questions must be answered for the exam to be scored.
IMPORTANT: Take this exam only after taking the previous final assessment exam. There are three final assessment exams. Thus, if you did not receive a
passing score on the first, it is critical that you review the course material carefully before taking this exam.
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Good Luck!
Revenue and Receivables

So far in the tutorial you have been introduced to the accounting concepts, the accounting recording system and the basic financial statements. In the rest of the tutorial you are going to
look more closely at the accounting for specific operating, investing, and financing transactions.
In this chapter, you will expand your understanding of accounting for the operating items revenues and accounts receivable. As in the earlier chapters you will learn through doing. You
will resolve the October accounting concerns related to revenue and accounts receivable that arose during Global Grocer's preparation of its October financial statements.
Review
Before moving on, you may want to review the basic revenue recognition concept studied earlier. As you will recall, revenue is recognized when it is earned and realized or realizable.
Earned: In most cases, revenue is earned when a sale has taken place, which is when:
the customer has agreed to buy the goods and services;

the goods or services have been delivered; and
the seller has performed substantially all of its obligation to the buyer
Realizable: The realized or realizable criterion is satisfied if the seller has received payment or reasonably expects to be paid.
Exercise 7.1
During the month of October, Global Grocer's business picked up quite a bit. October sales were more than triple sales for September.
Before considering some additional sales related transactions that you will look at in a moment, the company made cash sales for $19,000, credit sales for $45,000 and collected
$5,000 from customers settling up their accounts. The balance in the accounts receivables on October 1 was $5,000.
Let's make the journal entries for the October sales, receivables and collections, and then post them to the General Ledger.
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The ledger balances are now transferred to the Balance Sheet and Income Statement, and the Sales account is closed out.
1. Sales equal cash sales plus credit sales.

2. Accounts receivable are last months' balance plus this month's credit sales less this month's collections from customers.
Issues
While preparing the end-of-month financial statements for October, several concerns arose. You decided not to include these events in your financial statements until you had a
chance to study them and identify the proper accounting method. They were:
A customer purchased a gift certificate during October. It has not been redeemed by the end of October.
You believe that several customers who owe you money may not be able to pay their bills in full.
Several customers returned merchandise during October. You believe some of your October sales may be returned in November.
In order to generate cash, you gave your larger customers the opportunity to receive a 2% discount if they paid their account within 10 days of their purchases.
Unredeemed Gift Certificate

In early October, Global Grocer introduced gift certificates. Two gift certificates had been sold but only one had been redeemed for merchandise within the month. The last certificate -
for $80 - was still outstanding.
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From an accounting perspective, the sale met the realization criteria since the customer paid for the certificate when it was purchased. However, as of the end of October the revenue
had not been earned as goods or services had not been delivered.
Since one of the necessary criteria for recognizing revenue has NOT been met, the gift certificate should not be included in the sales revenue totals for the month. How then should it
be recorded?
Deferred Revenue
In order to record Sarah Jane's $80 gift certificate, you need to create a new account called "Deferred revenue". Deferred revenue is future revenue that has already been collected
but has yet to be earned. It is shown in the liabilities section of the balance sheet, reflecting Global Grocer's obligation to provide merchandise to the holder of the gift certificate in
the future.
Let's now record Sarah Jane's initial gift certificate transaction in the general ledger accounts.
Now we can move the transaction from the general ledger to the monthly financial statements. Remember, this sales transaction must remain on the balance sheet and cannot go
into the income statement as revenue until it is both earned and realized.
Here are the end-of-month October financial statements showing the addition of the "deferred revenue - gift certificate" account.
Redeeming Certificates
How is the redemption of the gift certificate recorded? Let's jump ahead to November. It is Sarah Jane's birthday and she redeems her $80 gift certificate. At that time, the revenue
will be moved from Deferred Revenue to Sales. This is how you will record the November transaction.
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Exercise 7.2
Assume another gift certificate sold by Global Grocer for cash in October had not yet been redeemed. This certificate was for $60. Make the necessary entries at month's end below.
In November, the $60 gift certificate sold in October is redeemed for merchandise. The cost of the merchandise is $40. Make the accounting entry for the redemption of the gift
certificate below.
Then make the entry for the sold merchandise. If you need to review how to record cost of goods sold and merchandise inventory transactions, go back to [Accounting Records:
September accounts: COGS Entry].
Bad Debts
In early October, Global Grocer made a credit sale of soft drinks to a local company. A week later, Global Grocer learned that the company had declared bankruptcy and there would
be no hope of recouping the money owed to Global Grocer. You wrote off the company's receivable, but wondered if there would be other similar situations in the future which might
mean your end of October accounts receivable may not all be collected.
You decide to do what many companies do - create an allowance for bad debts. The purpose of an allowance account is to record your accounts receivable at the amount you expect to
receive in the future.
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Let's see how this is done.
Estimation
Step 1: Estimate Bad Debt Amount
To create an allowance, Global Grocer must start by estimating the amount of its October accounts receivable that might eventually become bad debts.
Based on their past experience, some companies assume that bad debts will be a constant percentage of accounts receivable. Not knowing which accounts receivable will actually not
be paid, they use the percentage to calculate the allowance for bad debts. For example, at the end of 4 months you will be able to age your accounts receivable by how old they are.
Based on this analysis you will be able to make a better estimate of your bad debt allowance.
For example, for Global Grocer, October 31 accounts receivable totaled $45,000. If you expect $900 or 2% of these receivables will not be collected, you will use $900 as the
estimate for the October bad debt allowance until you have more data to go on. In future months, you will know more about the specific accounts and amount of bad debts and will
be able to modify the estimate if necessary.
Allowance Set Up
Step 2: Set up an allowance account & record bad debt expense
To record the bad debt expense two new accounts must be set up - the allowance for bad debts account and the bad debt expense account. For journal entry purposes, the allowance
for bad debts account is treated like a liability account. The bad debt expense account is an income statement account. To recognize the estimated $900 bad debt expense, this
income statement account is debited $900. The offsetting $900 credit entry is to the allowance for bad debts.
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Here are the end of month October financial statements before recording an allowance for bad debts. (And before the two adjustments to gross sales we will discuss next)
Write-offs
The final step is to record a bad debt write-off when it becomes clear that a particular customer cannot pay the debt.
Step 3: Record bad debt write-off
Again, let us jump ahead to November. You learn that a sale of $155 made in October will never be paid by the customer. Here is the journal entry that you would make to record the
event and its impact on the general ledger.
Notice the write-off of the $155 account receivable does not create an expense. The expense was already recorded in October when the allowance for bad debt was set up.
Exercise 7.3
Global Grocer established an allowance for bad debts at the end of October. In November, Global Grocer wrote off a $200 account receivable because payment was considered to be
remote. What would be the effect of the $200 account receivable write-off be on Global Grocer's November financial statements?
Refunds
In October, Global Grocer sold tomatoes to a customer for $43. The next day, the customer returned the tomatoes, complaining that they were quite tasteless. You gave the customer a
full refund and wrote off the cost of the returned bad tomatoes. At the end of October, you thought there might be more returns of produce sold in October in November. You
recognize that if October sales are returned in November and you ignore this possibility, October sales will be overstated.
You decide to use the allowance method to account for the possibility of future returns of October sales, in much the same way that you used the allowance method to account for the
possibility of bad debts.
Estimating
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Step 1: Estimate Sales Returns
Most companies make an estimate of the amount of their sales that will be returned based on previous experience. For Global Grocer, you estimate that there may be three more
large returns of tomatoes as well as some other goods, that had been sold in October for $200.
Once Global Grocer had more experience in the business, its estimates would be based on more complete information using its records showing refunds over several months or
years.
Allowance Set Up
Step 2: Set up the liability allowance account and sales refund allowance deduction from gross sales account.
To recognize the returns and accompanying refunds, you create a liability account called "Allowance for sales returns". The account represents the amount of refunds the company
expects to make on October sales during future accounting periods. The Estimated Sales Refund account balance is a deduction from gross sales. On the income statement this
account is renamed and appears as "Allowance for sales returns." Do not let this renaming of the income statement account confuse you. The liability account of the same name is
still on the balance sheet.
Here is how the balance sheet and income statement for Global Grocers will look after the addition of the allowance for refunds.
Actual Returns
Step 3: Record actual returns
Let's now see what happens when a customer who purchased tomatoes for $55 in October returns for a refund in November.
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Exercise 7.4
If, in November after Global Grocer created the refund allowance account at the end of October, a refund for $30 was given to a customer, what would be the effect of the $30
refund on Global Grocer's November financial statements?
Prompt Payment Discounts

As owner of Global Grocer, you realized you could generate cash faster if your credit customers paid for merchandise as soon as possible. To give them an incentive to do so, toward
the end of October you began offering a 2% discount on the amount owed if customers pays within 10 days of their purchase. This is known as a prompt payment or cash discount.
In total, out of ten customers in October, five had already taken advantage of the offer. At the end of October, four more customers were still eligible to benefit from the discount. Sales
to these customers total $4800. If the customers take advantage of the prompt payment discount in November, your October 31 accounts receivable balance will be overstated. You
decide to set up an allowance account for discounts in anticipation of prompt payments by some of these customers.
Estimation
You followed the same steps as you did for the other allowance accounts:
Step 1: Estimate the Allowance for Cash Discounts
Like the other two allowance methods, you use the company's past experience to estimate the allowance.
In October 5 out of 10 got the discount...
so 50% of remaining customers might take the discount:
4 X .5 = 2
Credit sales to the four customers = $4800
Discount estimate = $4800/2 customers X the discount of .02
=$48
Allowance Set Up
Step 2: Set up the liability allowance account and cash discount allowance deduction from gross sales account.
The allowance for cash discounts is a liability account. The corresponding account - Estimated cash discounts - is shown in the income statement as a deduction from gross sales.
Like the sales refunds adjustment to gross sales, this income statement account is also renamed in the income statement. It will appear as "allowance for cash discounts". Do not be
confused. The liability of same name is still on the balance sheet.
Here are the journal entries necessary to create the two accounts.
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Here is how the balance sheet and income statement for Global Grocer will look after the addition of the allowance for cash discounts.
Cash Collections
Step 3: Customer pays and takes discount
Again let's move ahead to November. A customer pays in time to receive the cash discount. This customer purchased $500 worth of goods and will receive a $10 discount.
Here are the journal entries to record the payment transaction and the discount. Note that three accounts are affected by the entries - accounts receivable, cash and allowance for
cash discounts.
Exercise 7.5
Another Global Grocer customer pays in time and receives the 2% discount in November. The customer purchased goods worth $100. What are the entries to record the payment
and the discount.
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Adjusting Allowances: Month's End

Again, let's jump ahead to November. This time to November 30. You are in the midst of preparing the end-of-month statements for November. As for other general ledger accounts,
you will tally up the transactions made to the allowance accounts during the month.
You then need to adjust the allowance accounts to the correct end-of-November balance, reflecting the new estimates for bad debts, refunds, and discounts. Your entries must also
take into account the errors in your estimates left from the previous month.
For example, here are the November transactions posted to the bad debt allowance account. You estimated correctly that bad debts on October receivables would total $900, so the
end-of-month balance in that account is zero. There was no error in your estimate of bad debts - you were "right on"!
Updating
Let's now make the adjustment to the balance in the bad debt allowance account, updating it to reflect a new estimate for bad debts at the end of November.
Overestimations
Let's now adjust the allowance account for cash discounts.
At the end of October, you estimated that the actual discounts taken would be $48. In fact, the discount expense was only $25. You had overestimated, so at the end of November
there was a credit balance of $23 still in the allowance account.
You decided to modify your estimate for this month. You made new calculations for November and your estimate for cash discounts at the end of November is $80.
The balance in the allowance account should therefore be $80 going forward. To bring it to $80 from the present $23, a credit entry for $57 needs to be made to the account and a
corresponding debit entry to cash discounts.
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Here are the entries to the accounts and their impact on the General Ledger. Note that the entry for $57 simultaneously solves the issue of the estimation error from October as well
as the need to create a new allowance for cash discounts on November sales.
Underestimations
Finally, let's look at the allowance for refunds. Last month, you gave a dollar estimate of $200 for refunds. Refunds were actually $220. You underestimated the number of refunds
and there is a debit balance of $20 in the allowance for sales refunds account. This must be corrected.
For November, you decide to increase the allowance to $300. The balance in the allowance account should therefore be $300 going forward.
To bring the allowance account for refunds to $300, a credit entry of $320 must be made and a corresponding debit entry of $320 to the estimated refund account.
Note that the entry for $320 simultaneously solves the issue of the $20 estimation error from October as well as the need to create a new allowance for refunds on November sales.
Exercise 7.6
Here is an example of a company with a bad debt allowance. As you can see, at the beginning of the month of June, the balance in the bad debt allowance account was $500. Shown
here are also all the transactions in the allowance account during the month.
For July, the company wants to increase its bad debt allowance to $600.
Make all the necessary entries to increase the bad debt allowance to $600 for the next accounting period.
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Ratios
Financial analysts incorporate account receivables in ratios to gain some insight into the quality and reliability of current assets and their ability to generate cash in the future. The
following two ratios represent some of those most commonly used.
Bad debt allowance to gross accounts receivable

Turnover of accounts receivable or "days receivable" or "days sales outstanding" or simply "DSO's"
Let's see how each is calculated and interpreted.
Bad Debt Ratio

The bad debt ratio is the percentage of a company's gross receivables that it does not expect to be paid. A company with a low bad debt ratio believes it is more likely to receive
payment of more of its receivables outstanding than a company with a high bad debt ratio. Financial statement users use the bad debt ratio against their knowledge of the issuers'
business and industry to assess the reliability of the company's net accounts receivable balance. The ratio is calculated as follows:
Interpretation
Bad debt ratios vary considerably from industry to industry, ranging from less than 1% to over 15%. Companies in health and communications industries have a higher bad debt
ratio than those in the energy or defense industries. Below is a table with bad debt ratio of several communication companies. While their ratios vary considerably from each
other, overall they are fairly high as compared with companies from other industries.
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Analysts look to see if a company's bad debt ratio is increasing over time, or if it is significantly greater than that of other companies in its industry. In either case, this might
indicate that the company is failing to properly screen potential clients before offering them credit. It might also mean that the company is pursuing less credit-worthy customers
in an attempt to generate sales which it is not getting elsewhere.
From a managerial perspective, the greater your company's bad debt ratio is, the more it costs you to extend credit to your customers. If you are attempting to analyze the
incremental profitability of a sale, the cost of providing credit to a customer is one of the costs elements to include. An increase in the cost of extending credit means a decrease in
net profit from a sale.
Exercise 7.7
What is Global Grocer's bad debt ratio for October?
Here are some relevant figures:
Allowances for bad debts: $900

Gross Accounts Receivables: $45,000
Days Receivable Ratio

The "days receivable" ratio or the "days sales outstanding" (DSO) ratio indicates the average number of days necessary for the company to collect its outstanding accounts
receivable. The days receivable ratio is sometimes called receivables turnover, because it tells you how fast the receivable are turning over and being converted into cash.
To calculate days receivable, the formula is:
Days Receivable = Net accounts receivable X # of days in the period

Total sales in the period
Interpretation
As is true with bad debt ratios, days receivables varies considerably between industries. Retail apparel chains have very short days receivable while heavy equipment
manufacturers, by comparison, have much longer days receivable.
Here are the days receivables averages from several different industries. They vary from as few as 1 day for financial service firms to as many as 52 days for the mining industry.
Analysts compare a company's days receivables to that of its industry peers. The slowing of a company's days receivables or a high days receivables compared to its competitors
has a negative impact on the firm's liquidity; it ties up capital that might otherwise be used to finance the production of saleable assets. An increasing days receivable ratio might
also be an indication that more of the receivables will become bad debts.
In periods of economic downturn, many companies experience an increase in days receivable and bad debts as their customers find it more difficult to meet their obligations.
Exercise 7.8
The Density Company produces plastic liners for cooking products.
Here are some relevant figures concerning their activities for the year 2005 (365 days):
Total sales: $16,080 million

Net Accounts Receivable: $2,569 million
What is Density Company's Days Receivable for 2005?
At the end of a full year of operations, Global Grocer's total sales and net receivables are as follows. You want to know what Global Gorcer's days receivables are.
$2,574,361 in total sales

$197,485 in net receivables
Calculate Global Grocer's days receivable using the formula. What do you get?
Recap
In this chapter, you learned more about how to account for specific transactions concerning revenues and accounts receivable.
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For receivables, you were introduced to the concept of deferred revenue and how to handle certain transactions where the basic criteria for revenue recognition are not met at
the time of sale.
For bad debts, refunds, and prompt payment discounts, you learned how to create allowance accounts and how to manage those accounts over multiple accounting periods.
Finally, you were also introduced to two important ratios used to evaluate accounts receivable: the days receivable ratio and the bad debt ratio.
Here are the updated statements with the tax effect of the month's transactions taken into account.
Inventories and Cost of Sales

In this chapter, we will look more closely at accounting for inventories and the cost of sales.
So far we have assumed that inventories consist only of purchased finished goods immediately ready for sale. These inventories are known as bought merchandise inventories. We
will first review accounting for bought merchandise inventories.
Global Grocer will then expand its activities into manufacturing and you will learn about calculating the cost of goods sold for a manufacturing operation and accounting for
manufactured inventories that are a mix of raw materials, work-in-process and finished goods.
Later in the chapter, Global Grocer will find that the input prices for some of the merchandise that it has purchased have changed, raising questions about how to record inventory
and cost of goods sold. You will be introduced to different approaches for valuing inventories that deal with this challenge, in particular, the Last In, First Out (LIFO) and First In,
First Out (FIFO) methods. Each of these methods also has implications for measuring the cost of goods sold.
Finally, some of Global Grocer's inventory will be damaged and you will be introduced to the "lower of cost or market" rule which we use in such cases to determine the new value
for inventory.
As in the earlier chapters you will learn through doing. You will resolve Global Grocer's October accounting concerns related to the cost of goods sold and inventories for the new
manufacturing operation and prepare the company's November financial statements.
Review of Matching
Before moving on, let's review the key concepts that affect the reporting of inventory and cost of sales: the historical cost and matching concepts studied earlier.
As you will recall, goods available for sale are held in inventory at Global Grocer at the cost at which they were purchased. That is their historical cost. When the inventory is sold, the
cost of the items becomes part of cost of goods sold (COGS) for the period, ensuring that the cost of the goods are "matched" to the revenues from the sale.
Here is the table from Chapter 4: The Income Statement (The Income Statement: Concepts: Matching Concept) which summarizes the requirements for expense recognition
according to the matching concept. Additionally, a discussion of the Historical Cost concept can be found in Chapter 3: Balance Sheet: Concepts: Historical Cost.
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Bought Merchandise Flow

Here is the flow of inventory costs for a merchandise operation that buys its finished goods. Goods are purchased ready for sale from suppliers and held in inventory until they are
sold. When they are sold their cost is moved to the cost of goods sold (COGS) account. As such, they move from the Balance Sheet to the Income Statement.
Merchandise COGS
In the month of November, Global Grocer recorded $89,000 in bought merchandise sales. You need to calculate the cost of goods sold (COGS) related to these sales. To do so, recall
that the change in inventory during a period is simply the difference between purchases (which increase inventory) and transfers from inventory to cost of goods sold (which decrease
inventory). Cost of goods sold can then be calculated using information on the beginning and ending inventory values and purchases as follows:
Cost of Goods Sold = Beginning Inventory + purchases - ending inventory
Exercise 8.1
Bought merchandise inventory on hand on October 31, 2014 was $51,000. During November, 2014, Global Grocers purchased additional merchandise costing $62,000. A count of
bought merchandise inventory on November 30, 2014 indicated that inventory costing $46,000 remained.
What was the cost of goods sold for bought merchandise inventory sales during the month of November?
Journal Entries
Let's now make the November journal entries for bought merchandise. We begin with the $62,000 November merchandise inventory purchases. Assume the purchases were all
made on credit. Next we will record the November merchandise cost of goods sold.
Remember, beginning inventory was $51,000; the cost of goods sold was $67,000, and ending inventory was $46,000.
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Update the Financials

The cost of goods sold account is closed out to the Income Statement and the remaining ledger balances are now transferred to the Balance Sheet. A partially updated balance sheet
and income statement as of November 30, 2014 are shown below.
As you will soon discover, some additional transactions will be included later.
New Challenges
In November, you encountered several additional accounting challenges related to Global Grocer's inventory accounting that have not yet been recorded:
Jam manufacturing operations were launched during the month and you wonder how to account for inventories and cost of goods sold under these circumstances.
You received two shipments of the same Dijon mustard at different prices. Now, you need to determine COGS for the mustard sold.
During a nasty rain storm some cases of your gourmet French tea were damaged. You need to record the change in value of your inventory.
Jam Production
In November Global Grocer launched a jam manufacturing operation. By the end of the month, the company had inventories of uncooked berries, jam jars, and some jam that was
still cooking. It had several finished jam jars awaiting sale and had already sold others. The issues you need to address are:
Jam production required new outlays for labor, ingredients, cooking materials, etc. How should these outlays be recorded?
Some of the jam was still in production at the end of November. How should you value jam that is halfway through the cooking process?
What did it cost to produce a jar of jam?
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How do you determine the cost of the jam sold and unsold jam that remained in the store?
Process
Here is a diagram illustrating the flow of costs related to manufacturing operations like Global Grocer's jam production. In contrast to the diagram for retail operations, the
manufacturing operations diagram has three separate inventory accounts: Raw Materials, Work-in-Progress and Finished Goods.
Click on the mouse icon in the diagram to see which costs should go in each of these accounts.
Abbreviations are frequently used for two of these accounts. The work-in-process inventory account is often referred to as "WIP" and the cost of goods sold account is known as
"COGS".
Raw Materials: the costs of materials on hand but not yet placed into production. Delivery costs related to obtaining the raw materials would also be included here.
Work-In-Progress (WIP): the cost of raw materials on which production has been started but not completed plus the direct labor applied specifically to this material and a
share of manufacturing overhead costs, which are manufacturing related costs other than direct labor and materials.
Finished Goods: costs identified with completed but unsold units on hand at the end of the accounting period.
Cost of Goods Sold (COGS): costs identified with the goods sold to customers during the accounting period
Exercise 8.2
Here is a list of costs from a spaghetti manufacturing company. Assign these costs to the account where you think they fit into the manufacturing process by selecting the cost
with your mouse and dropping it into the appropriate account box.
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Costs
Let's look at how to account for Global Grocer's first manufactured product , red raspberry jam. To manufacture red raspberry jam, Global Grocer converted the back of the
warehouse into a kitchen. A stove and cooking equipment was purchased. During November, the following outlays and charges were incurred:
1. $14,500 for red raspberries, sugar and glass jars

2. $700 in delivery charges upon receipt of the raspberries and other materials
3. $3000 in labor costs for the new jam chef
4. $600 in labor costs for supervisory work by your operations manager
5. $250 in labor costs for cleaning the administrative office
6. $8000 for a stove and cooking equipment (paid in cash) - $80 in depreciation expense is to be recorded per month
7. $500 in maintenance materials for the cooking equipment
8. $150 in publicity to launch the jam sales
Some of these expenditures should go to the inventory accounts and some to other accounts. You will need to determine where each one goes.
Costs Included
Manufacturing inventories are recorded at the cost of production. The costs included are those directly connected with purchasing and transporting materials to the production
site and converting them to a finished product. These are termed product costs.
All product-related costs remain in inventory until the goods are sold. Then, costs for the goods sold are transferred to COGS at the end of the accounting period.
There are different kinds of product costs. The main ones are listed here:
Labor: The compensation of all manufacturing labor that can be traced to the production of the product.
Materials: Acquisition costs of all materials that eventually become part of the product.
Manufacturing Overhead: Manufacturing costs that are closely related to the making of the product, but that are not specifically production labor or materials.
Depreciation on manufacturing equipment is an example.
Costs Excluded
Selling expenses, and administrative expenses are not included in manufactured inventory costs and/or COGS. They are considered to be operating expenses, not product costs,
and are expensed as incurred.
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Examples are:
Advertising costs for the product

The cost of the running the purchasing department
Office cleaning expenses
Bought merchandise inventory is also not included in the manufactured inventory account. Their costs are assigned to a separate inventory account.
Product Costs
Let's revisit the list of outlays and charges associated with Global Grocer's jam operation in November. Which are costs related to the production process (to be included in
inventory and/or COGS)? Which ones are not?
Using the drop down fields, indicate whether you think that the cost should be included in inventory?
The process by which costs such as those listed here are allocated to products or to different activities within the company is known as cost accounting. If you would like to learn
more about cost accounting, refer to the HBS cost accounting online tutorial at the Harvard Business School Publishing website.
Inventory Accounts
By the end of November, Global Grocer had raspberry jam sales of $30,000. Following the matching principle, the costs of producing the jam that had been sold should be
transferred to the COGS account.
What amount should be transferred? Which costs went to producing the jam that was sold?
To determine this, let's look more closely at the three production inventory accounts, Raw Materials, Work-in-Process, and Finished Goods.
Raw Materials
The first step in the production process is the acquisition of raw materials. Once purchased, raw materials acquisition costs are debited to increase the Raw Materials inventory
account along with any associated delivery costs.
Here is the list of Global Grocer's costs for raw materials purchases. Make the entries and click "post it" to update the general ledger. All purchases were made on credit.
$14,500 for berries, sugar and jars

$700 in delivery costs
First do the entries for the $14,500 purchases and then the entry for the delivery costs.
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Work-in-Process
In most cases companies do not know the quantity of materials used in the production process until they have counted their raw materials inventory on hand at the end of the
accounting period. This is generally done by direct observation.
If you knew the inventory amount in the raw materials account at the beginning of the accounting period and the raw materials inventory amount at the end of the accounting
period, what other information would you need to calculate the raw materials put into production?
Finished Goods
By November 30, Global Grocer had made 6000 jars of jam. Although some jam still remained in production, you determined that $15,000 in costs had been incurred to
complete the jars already finished. This $15,000 cost of finished goods should be transferred to the Finished Goods inventory account.
To make the journal entry to transfer from the work-in-process account the cost of the jam jars made in November to the Finished Goods inventory account and update the
general ledger accounts, press the POST IT button below.
Tracking Inventory
There are two approaches to keeping track of inventories. They are the periodic and the perpetual methods. Under the perpetual method, the inventory account is adjusted as
each addition and withdrawal is made. We do not illustrate this method here.
The periodic method, as its name indicates, adjusts the inventory account periodically based on actual inventory counts. For example, at the end of each accounting period,
inventory on hand is counted and valued. This amount becomes the ending inventory.
The periodic method was used at Global Grocer to determine the ending raw materials, work-in-progress, and finished goods inventories.
Cost of Goods Sold
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Of the 6,000 jars of jam costing $15,000 made by Global Grocer, 4,000 jars costing $10,000 were sold. Only the cost of the finished jars of jam still on hand - $5,000 - should
remain in the finished goods inventory account. The cost of finished jars of jam sold should be transferred to cost of goods sold. Remember a total cost of $15,000 was incurred to
make all of the finished jars of jam.
Now, make the journal entries to transfer the cost of the jars of jam sold to the COGS account. Click on the "post it" button to update the general ledger accounts.
Financial Statement Update

Let's update the Balance Sheet and Income Statement for the raspberry jam production. We will also update it for the jam sales of $30,000 ($10,000 of these were made in cash;
$20,000 on credit)
Here, the general ledger balances transfer to the financial statements for the month ending November 30. To look more closely at the various depreciation accounts, click on the
mouse on the balance sheet. The related asset amounts are the asset's original cost (If you are unsure of the depreciation accounting used - do not worry. You will learn more
about depreciation accounting in the next chapter).
Exercise 8.3
You now know the cost to produce the 4,000 jars of jam sold in November by Global Grocer was $10,000.
You also know that the revenues generated by the sale of the 4,000 jars was $30,000.
What is the dollar gross margin on a single raspberry jam pot sold by Global Grocer in November?
Price Change
Let's now look at another November inventory accounting challenge. This one involves bought merchandise inventory.
In November, Global Grocer put in its first orders for Dijon mustard from France and subsequently received two shipments of the same mustard. Because of an exchange rate
change, mustard in the first shipment of 1,440 jars cost $2.00 a jar; versus $2.20 in the second shipment of 2,160 jars. At the end of November, you realize that you have sold some
mustard from both shipments, but you are not sure how many of each shipment since one bottle of mustard is indistinguishable from another. You realize that you have an
inventory accounting problem and you wonder what you should record for inventory and for COGS for the period.
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Complications arise when the prices of product inputs (materials and labor), or the prices of merchandise purchased for sale change. Any changes in input or purchase prices affect
both the cost of the products sold and the cost of inventory on hand.
When inventory cost changes occur, managers must choose which products the change in input or purchase prices should affect - those that have been sold or those still in
inventory.
Inventory Valuation
For Global Grocer, the cost of the mustard purchased for sale increased with the change in the exchange rate - from $2.00 to $2.20. 1,440 jars were received at $2.00 and 2,160
jars at $2.20. You sold 2,400 jars in November and need to know the cost of the 2,400 jars sold. But, remember your dilemma, you don't know which shipment the jars sold came
from.
If you assume that all of the second shipment's $2.20 mustard jars were sold before the $2.00 ones, then COGS would be higher and ending inventory lower than if you assume
that all of the first shipment's $2.00 mustard jars were the ones sold first. In this case, COGS would be lower and ending inventory higher.
Which approach should Global Grocer use? Each of these inventory accounting approaches based upon the assumed flow of costs gives a different answer.
Flow Assumptions
One way to think about how to value inventory and COGS when there are cost changes is to imagine that inventory is stored in a large tub in successive layers. To get the
inventory out, you can either empty it from the bottom of the tub, or from the top. Two of the most frequently used inventory costing approaches are "FIFO" and "LIFO." FIFO,
which stands for First In First Out, assumes that you empty the tub from the bottom, so that the earliest layer of inventory costs would be the first removed and put into COGS.
LIFO, or Last In First Out, assumes that you draw from the top of the tub, so that the most recently added layer of inventory costs would be the first taken out.
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Cost vs. Physical Flows

It is important to remember that different inventory accounting methods, such as FIFO and LIFO, reflect different assumptions about the flow of costs out of the inventory
account. These cost assumptions do not necessarily reflect the actual physical flow out of its physical inventory, which may be very different altogether.
For example, if we were a bread manufacturer, we could use a LIFO cost assumption for financial reporting on bread inventories, but when it actually came to selling bread we
would clearly want to sell the oldest loaves first. Otherwise, our physical bread inventory would consist of moldy loaves.
FIFO
The FIFO or "First-In, First-Out" inventory valuation approach assumes that the cost of products coming into inventory first are also those costs that relate to the current sales.
As a result, the costs of more recently purchased/produced goods are those costs remaining in the inventory account.
Here is an example of a company that sold 250 computers. In the first part of the month, 100 computers were produced at a cost of $500 each. Later in the month, 200 of the
same computers were produced at a cost of $600 each. To see what the inventory value is using FIFO, click the play button.
FIFO Cost Flows

Here is a visual representation of Global Grocer's situation using the "tub" to show the flow of costs for mustard under FIFO. The cost of mustard jars purchased first - those at
$2.00 - are those that go into the COGS calculation first. Remember, Global Grocer sold 2,400 jars of mustard during November.
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Exercise 8.4
Let's practice the FIFO method by calculating Global Grocer's ending finished mustard inventory. We know that COGS equals $4,992, as shown in the diagram below (from
previous screen). The inventory "tub" after taking out the COGS costs now only has one layer of cost left in it - jars valued at $2.20 each.
Calculate the ending inventory. Remember that 1,440 jars at $2.00 and 2,160 jars at $2.20 were purchased; in total, 2,400 jars were sold. Choose the appropriate values for
COGS and total inventory at the same time.
LIFO
The LIFO (Last-In, First-Out) approach uses the opposite cost flow assumption to FIFO. Under LIFO cost of goods sold is calculated assuming that the cost of the most recently
purchased/produced goods in inventory are the ones that are sold first.
Here is a look at our "tub" using the LIFO cost assumption. Under LIFO, the cost layers in our tub are drawn from the TOP and the cost of the most recently added layer is
included first in the calculation of COGS.
Exercise 8.5
Let's now calculate Global Grocer's mustard inventory and COGS using the LIFO method.
Remember, 1,440 jars arrived in the first delivery costing $2.00 a jar. 2,160 jars arrived in the second delivery costing $2.20 and 2,400 jars of mustard were sold.
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To practice what you learned about inventory calculation, let's take the example of a company selling toy trains on the internet. Here is the information concerning one of the
train models in its inventory.
Question: If the company wants to keep COGS for this train model low in order to record higher profits, which inventory method should it adopt? The company sold 1,700 X22
Speed-thru trains in the accounting period.
Comparison
Here is Global Grocer's inventory and COGS under FIFO and LIFO. For Global Grocer, LIFO results in higher COGS (lower earnings) and lower inventory valuation than FIFO.
This difference arises because the cost of the mustard merchandise increased during the month of November. If the cost of mustard had fallen, FIFO would have generated
higher COGS and lower inventory.
Firms choose LIFO or FIFO for a variety of reasons. But one important consideration is taxes. Under the US tax code, if a company uses LIFO for tax return purposes, it must
also use LIFO for financial reporting purposes. As a result, in the US, many companies whose merchandise or production costs are rising with inflation tend to use LIFO since it
enables them to report lower taxable income and to pay lower taxes than under FIFO. In contrast, companies with falling per unit inventory costs, such as firms in the computer
and electronics industries, tend to use FIFO because this method leads to lower taxable income for their firms.
LIFO Reserve
US GAAP requires companies using LIFO to disclose in the notes accompanying their financial statements the FIFO cost equivalent of their LIFO inventories. The cost
difference between FIFO and LIFO inventory is called the LIFO reserve.
For Global Grocer, the LIFO reserve only applies to the Dijon mustard inventory at the end of November. This is because, apart from the Dijon mustard, no price changes
occurred for any of the other goods in Global Grocer's inventory. Also, this is the first month that Global Grocer has purchased Dijon mustard and, thus, there is not any
mustard from previous periods in inventory.
The term LIFO "reserve" applies to the difference between the inventory cost under LIFO and FIFO. To arrive at the amount, you simply subtract the LIFO inventory cost from
the FIFO inventory cost.
What would be the amount of the LIFO reserve for Global Grocer?
Global Grocer's Dijon mustard inventory and COGS under the two methods is shown here.
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Exercise 8.6
Here is the information from Ford Motor Company's 2012 Annual Report showing 2011 and 2012 inventories at FIFO before the calculation of the LIFO reserve ($millions):
If Ford's balance sheet shows total inventories after the adjustment for the LIFO reserve at $7,362 MM for 2012, what is the amount of the LIFO reserve for 2012?
LIFO Accounting
After learning all about LIFO and FIFO, you decide to use LIFO for Global Grocer's inventory valuation. Let's make the entries. Mustard purchases and sales of mustard to
customers have already been accounted for. You just need to make the entries to transfer the cost of the mustard sold to COGS according to LIFO.
Remember, the amounts under LIFO are as seen below. We will update the balance sheet and income statements to reflect the new inventory and COGS amounts under LIFO
in a few moments.
Specific Identification
Inventory methods other than LIFO and FIFO that you should be aware include the specific identification and average cost methods. These methods are not as popular as LIFO
and FIFO, and so we will not discuss them in detail.
If you had been able to keep track of each and every mustard jar at Global Grocer, you might be able to use the "Specific Identification" method of inventory valuation because
you would know exactly which jars you sold and what they cost.
While this method resolves the question of where to assign the change in input costs, for companies with large inventories or undifferentiated products, it would be very time
consuming and costly.
The specific identification inventory method might be used, for example, by a dealer in rare antiques who followed closely the sale of each item.
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Average Cost
Another method is the "Average Cost" method. To determine the cost of inventory and COGS, the weighted average cost of the goods in the period's beginning inventory and all
goods placed in inventory during the period is calculated. The new weighted cost per unit is used to cost COGS and ending inventory.
For example, for Global Grocer's mustard, the weighted average price would be calculated as follows (remember Global Grocer did not have a beginning mustard inventory
balance):
This would make COGS = $2.12 x 2,400 jars sold = $5,088.
Inventory would then be $2.12 x 1,200 (jars left in inventory) = $2,544.
Exercise 8.7
Match the following descriptions to the appropriate inventory calculation method by tracing an arrow. Hint: assume that multiple goods were brought into inventory at
different costs.
Inventory Write-down
On November 22, there was a terrible rain storm. A window in the warehouse blew open and the decorative paper packaging on 300 cans of gourmet French tea was destroyed.
The tea inside (in tin cans) remained untouched. Fortunately, the damaged tea could be sold.
You paid $9 a tin for the tea and now need to account for the impaired value of the inventory in your financial statements. You wondered what value to give to the damaged tins of
tea. You believe that a firm that buys damaged inventory would buy the damaged tea tins for $5 a can.
Lower of Cost or Market

Under normal circumstances, inventory is reported at its cost - the cost at which it was purchased or produced. If an event occurs, such as the rain storm, that reduces the
value of the inventory below its original cost, the inventory must be written down to its new selling price less the cost of disposal. This requirement is referred to as the "lower of
cost or market" rule.
The accounting entry to write the inventory down to its lower value is:
Debit: Cost of goods sold (to charge the write down to income)
Credit: Inventory (to write the inventory down to its new value)
Entries
Once you have determined the new value for the damaged tea, you need to make an entry in Global Grocer's accounting records to reflect the change in inventory value.
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Global Grocer's 300 tins of damaged tea cans had a prior value of $9 x 300 = $2,700; their new value is $5 x 300 or $1,500. There was no cost of disposal. The amount of the
write-down is: $2,700-$1,500 = $1,200.
Make the journal entry below and click on "Post it" to have it transferred to the General Ledger.
Updating the Financials

Let us now update Global Grocer's financial statements with the changes to Inventories and Cost of Goods Sold.
Inventory Ratios
Effective inventory management is an important determinant of how well a company manages its working capital (current assets - current liabilities). The shorter the time period an
item is in inventory, the lower the average investment in inventory. Two ratios - inventory turnover and days inventory - are used to gauge the effectiveness of inventory investment
management.
Turnover
The "inventory turnover" ratio measures the average number of times inventory is sold during the year. Turnover is computed by dividing Cost of Goods Sold by the average
inventory on hand during the year.
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Let's look at an example to see how it works. Here is the data for a fictitious company - Foosie Corporation - for the fiscal year 2014:
Days Inventory
The "days inventory" calculation converts the turnover ratio to its days equivalent. The formula for computing days inventory is 365 divided by the turnover ratio:
365/(COGS/Average Inventory)
Let's look again at Foosie Corporation. Foosie Corporation's inventory turnover was 14.4. To convert it to days inventory, divide 365 by the inventory turnover of 14.4 to get days
inventory of 25. On average it took 25 days (365/14.4) for Foosie Corporation to sell its stock in inventory.
Interpretation
Desirable inventory turnovers vary considerably from industry to industry and company to company. Managers keep a close eye on inventory turnovers for signs of inventory
build-ups which could indicate obsolescence or anticipated sales growth in the next period.
Whether a company uses LIFO or FIFO has an impact on inventory ratios; if input costs are increasing, days inventory for a company under LIFO will be lower than under FIFO.
This can make it difficult to compare the inventory ratios of companies when some use the LIFO method and others the FIFO method. One way to overcome this problem is to
convert a LIFO inventory amount to its FIFO value equivalent by adding the LIFO reserve back to the LIFO inventory amount and then using the LIFO inventory's FIFO
equivalent to compute inventory ratios.
Exercise 8.8
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Let's now calculate days inventory for Global Grocer. Generally days inventory is calculated for a year period. Since we do not have a year's worth of results for Global Grocer, we
will calculate the turnover rate for three months (one quarter) of activity to date. This turnover rate can be converted to an annual equivalent by multiplying the turnover rate by 4
(4 quarters in a year).
We know that Global Grocer began operations on September 1 with $19,000 of inventory and its inventory (bought together with manufactured) balance on November 30, 2014
was $49,048. During this period, the cost of goods sold totaled, $134,432 ($7,500 in September, $43,500 in October, and $83,432 in November).
What is the annualized inventory turnover rate and the days inventory for Global Grocer?
Recap
In this chapter you learned how to account for inventories and cost of goods sold, both for a merchandising operation and a manufacturing operation.
For manufacturing, you learned what expenses go into the cost of producing a good and were introduced to the three inventory accounts used by manufacturing
companies: raw materials, work-in-process, and finished goods.
To be able to account for the cost of goods when input prices change, you learned about alternative approaches to inventory valuation, including LIFO and FIFO and the
impact of their use on the balance sheet and the income statement. Recall that IFRS does not permit LIFO.
You saw how damaged inventory led to a write-down from applying the "lower of cost or market" rule, which requires that a loss be recognized when the market value of
particular inventory items falls below their historical cost.
Finally, you were introduced to two new ratios: Days inventory and Inventory turnover. These ratios provide information about how effectively inventories are being
managed.
Using your new knowledge, you updated Global Grocer's balance sheet and income statement for the month ending November 30, 2014. Here are the updated statements.
Depreciation and Non-Current Assets

In this chapter you will learn about long-lived non-monetary assets and how to account for them. Key management challenges you will cover include:
How to account for the acquisition, improvement and disposal of long-lived assets,
How to estimate and account for the use of a long-lived asset over time, which accountants refer to as depreciation,
When to recognize "intangible assets", a special category of long-lived assets.
Global Grocer's business has grown progressively over the past months and has led to an increase in its long-lived assets. We are now at the end of December and you will have the
opportunity to make the entries to record the events in December related to Global Grocer's long-lived assets.
Let's start by reviewing what you already learned about assets and depreciation.
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What's an asset?
You previously learned that to be called an "asset" a resource has to meet four criteria. It has to be:
acquired at a measurable cost

obtained or controlled by the entity
expected to produce future economic benefits
the result of a past transaction or event
These four criteria apply equally to current assets and to long-lived assets. Long-lived assets differ from current assets in that they are expected to provide economic benefits beyond
one year, whereas, current assets are generally consumed or converted into cash within a year.
If you would like to review more thoroughly what you learned about the definition of an asset, you may refer back to the section entitled: The Balance Sheet: Assets.
Categories
Long-lived assets fall into one of two categories: tangible assets and intangible assets. Tangible assets can be seen or touched, whereas intangible assets are, as the name indicates,
without physical substance.
Examples of tangible assets are land, building, fixtures, equipment, and natural resources used in production such as a mine, fish reserve, or timber lands.
Examples of intangible assets are patents, copyrights, franchise licenses, and trademarks. Some intangible assets are referred to as "intellectual property". We will study other
examples of intangible assets in this chapter.
Key Concept
The accounting for long-lived non-monetary assets follows the historical cost concept. Under the historical cost concept, long-lived non-monetary assets (referred to as long-lived
assets in the rest of this chapter) are recorded initially at their cost, which is then allocated using a depreciation method to the periods during which the asset is used in business.
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Challenges
In preparing the financials statement for the end of December, 2014, you run into some accounting challenges concerning long-lived assets. These include:
Acquisition Cost: Global Grocer acquired a packaging machine for $18,000. Delivery and installation costs were $2,000 (total cost $20,000). How should you record the
delivery and installation charges?
Asset Usage: Following the purchase of the packaging machine, you need to account for the use of this long-term asset for the month of December.
Improvements: During the month, you spent $86,000 to repair and improve the warehouse. How should this outlay be recorded in your financial statements?
Asset Sales: Global Grocer's old delivery van was sold in December. How should you record the sale?
Intangible Assets: Global Grocer invested in research and development to create a new jam recipe that will be used next month. You even have a sample ready and wonder
how to record this transaction.
Acquisition Cost
On December 1, 2014, Global Grocer purchased a new packaging machine for the packaging of jam jars. It cost $18,000 and was delivered the same day. By the end of the day, the
machine was up and running. The cost to deliver and install it was $2,000.
It is now December 31, 2014 and you need to record the purchase and the costs for installation and delivery. Are the delivery and installation costs an expense, or should they be
considered part of the purchase cost of the packaging machine?
Capitalization
The acquisition of a fixed asset, such as Global Grocer's purchase of the packaging machine, is often referred to as a capital investment. Costs associated with the acquisition of the
asset that are incurred in bringing the asset to its intended location and to get it ready for use are "capitalized", i.e. included as part of the total cost of the asset that appears on
the balance sheet.
If the acquired asset is land, the realtor's fee and the cost of clearing or preparing the land for construction are capitalized and included in the total cost. If the acquired asset is
machinery, the cost of delivery, installation and, if necessary, the trial runs are all capitalized.
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Exercise 9.1
On December 1, Foosie Corp. acquired a new car from a dealer for $32,000. The company also paid $160 sales tax on the purchase, $200 for the annual car registration fee, and
$75 to fill the tank with gas. What would be the value of the new car in the company's books immediately following these transactions?
Accounting
Let's look at Global Grocer's packaging machine. You now know that the total capital investment in the packaging machine is the cost of acquisition - $18,000 - and the cost to get
the machine in place and up and running - $2,000. Global Grocer paid cash for these capitalized items. So Global Grocer's total investment is $20,000 and all of it must be
"capitalized".
You may now make the entries to record the addition of this asset to Global Grocer's balance sheet.
Click on the "post it" button to update the general ledger.
Asset Usage
The December acquisition of the packaging machine for $20,000 (discussed previously) raises the question of how to estimate the cost of using the machine during the month.
You will recall that the cost of usage is called depreciation. In earlier tutorial chapters, we told you the depreciation cost each month. But now it is time to learn how the cost is
calculated.
Depreciation
As an asset loses its ability to produce future economic benefits for the company, it is said to be "depreciating". This loss of future ability to produce benefits represents a cost to the
company which is recognized over the useful life of the asset. In accordance with the matching principle, in each accounting period a depreciation expense, based on the asset's
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original cost, is recorded as an expense in the income statement.
Accumulated Depreciation
Here is the breakdown of the warehouse and equipment asset account for Global Grocer at the end of November. It shows each of the tangible assets owned by Global Grocer and
their accumulated depreciation on November 30, 2014.
Methods
Managers are permitted to use a number of different methods to determine a firm's periodic depreciation cost. GAAP requires the depreciation method adopted be systematic and
rational. IFRS requires the depreciation method adopted reflect the pattern in which the asset's future economic benefits are expected to be consumed by the reporting entity. The
main methods used in practice are:
Straight-Line Depreciation: Under the "straight-line" method, the depreciation expense for a given long-lived asset is the same dollar value for each period of the asset's
useful life. Straight-line depreciation is the most commonly used method of depreciation. It has the advantage of being simple and a good approximation for most situations. It
assumes an assets ability to produce future economic benefits is used up at a constant rate over its life, which is a reasonable assumption for many assets.
Accelerated Depreciation: The ability of some assets to produce future economic benefits is used up at a declining rate over their life. The "accelerated depreciation" method
has been developed to allow for a "front-loaded" usage pattern, where the periodic depreciation expense declines steadily over the asset's useful life.
Straight-line method
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Under the straight-line method, the annual depreciation expense for an asset is estimated as follows:
Asset Cost - Estimated Salvage Value

Estimated Years of Useful Asset Life
Estimated Salvage Value: the salvage value of an asset is also a company estimate made at the time the asset is purchased. It is the the amount the company expects to
receive from disposing of the asset at the end of its expected useful life.
Estimated Years of Useful Asset Life: the useful or (economic) life of an asset is a company estimate made at the tiem the asset is purchased. It is affected by physical
deterioration over time, obsolescence and usage.
For example, if the cost of a car is $19,000, its expected useful life to the owner is 5 years, and its estimated resale value after 5 years is $3,000, then the amount of yearly
depreciation would be as follows:
$19,000 - $3,000 = $3,200 per year

5
Here is a graph of the yearly depreciation expense for the car using the "straight-line" method. Each year 20% of the car's depreciable value (its $19,000 cost less its estimated
salvage value of $3,000) will be depreciated.
After 5 years, the car will have a book value (its cost less accumulated depreciation) equal to its estimated salvage value of $3,000.
After several years of using an asset, a company may revise its estimates of the asset's useful life and salvage value. It can change these estimates and re-estimate the
depreciation expense for the asset going forward. But it may not revise the depreciation expense or accumulated depreciation recorded in prior years.
Exercise 9.2
You may now calculate the depreciation expense for Global Grocer's $20,000 packaging machine. Assume that the machine has a salvage value of $2,000 and a useful life of 6
years. What is the annual depreciation expense under the straight-line method?
Accelerated Methods
The most commonly-used accelerated depreciation method is the double-declining balance (DDB) method. Under the DDB method, the annual depreciation expense is
estimated as follows:
2 X Asset's Beginning Book Value

Estimated Years of Useful Asset Life
2:This is the rate of depreciation used under DDB. Notice that the rate is double the annual depreciation rate used under the straight-line method.
Asset's Beginning Book Value: The depreciation expense each year is based on the asset's beginning book value (i.e. its cost less the accumulated depreciation). Because
the book value for the asset declines each year, the annual depreciation expense under the DDB method also declines over the asset's life.
Notice that, in contrast to the straight-line method, DDB depreciation does not directly allow for an asset's expected salvage value. Instead, the asset continues to be
depreciated until its book value equals its salvage value, at which point no further depreciation expense is recorded.
Let's see how DDB depreciation works for our car that cost $19,000, has a useful life of 5 years, and a resale value of $3,000. The depreciation rate is 2/5 or 40%, which is
double the 20% rate used under the straight-line method.The annual depreciation expense for the car is as follows:
The car is depreciated down to its salvage value of $3000 after only 4 years. Actually, the full fourth year depreciation would have been $1,641.60 (40% x $4,104) which would
have made the ending book value lower than salvage. We therefore only record $1,104 of depreciation in year 4 so that the asset is not valued below salvage. Here is a graph of
the yearly depreciation expense for the car using the DDB method.
In the US since 1981, tax regulation has made it possible for companies to use an alternative accelerated depreciation method for tax purposes which allows them to depreciate
their assets even more rapidly than under traditional accounting methods. The objective of the legislation was to stimulate corporate investment. In many cases, companies
today keep two separate sets of depreciation schedules for their assets - one for tax purposes and one for financial reporting purposes.
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Exercise 9.3
In the table below, fill in the correct amounts for yearly depreciation expense and the end of year net book value of the asset under the Double-declining method. The straight
line method is shown for your information. The asset's cost is $25,000; it has a useful life of 4 years; and, a $5,000 salvage value.
To see if your answers are correct, click on the "Submit" button.
Accounting
After learning about the different methods, you decide to use the straight-line method to depreciate the packaging machine. You believe that this method best reflects the usage
pattern for the machine and is therefore a good way to allocate the cost of the asset to periods when the benefits of using the machine will be obtained. Yearly depreciation under
this method is $3000; the corresponding monthly charge is therefore $250 (3,000/12 months).
For assets such as the packaging machine, which are used to manufacture the firm's products, the depreciation expense is charged to Work-Process Inventory as a product cost
and subsequently transferred to Finished Goods Inventory and eventually to Cost of Sales. This process is discussed in the Inventories and Cost of Sales chapter. Let's now record
the journal entry for the packaging machine depreciation and post the entry to the general ledger.
IFRS Allowed Alternative

Earlier it was noted under an IFRS allowed alternative to the cost method, IFRS permitted property, plant and equipment after initially being recorded at cost to be measured
at its market value. Generally, any subsequent change in the asset's market value is recorded in other comprehensive income (see glossary).
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Improvements/Repairs
The third accounting issue you encounter concerns repairs and improvements made to Global Grocer's warehouse during the month of December.
The interior walls of the warehouse were reconstructed to provide better insulation for the goods stored within. The work cost $56,000, $30,000 paid in cash and the balance of
$26,000 payable in one month. In addition, the warehouse was repainted at a cost of $30,000, which had yet to be paid.
You wondered how these outlays should be recorded in Global Grocer's financial statements.
Asset/Expense
The cost of any improvements or "betterment" to an existing asset must be capitalized. A betterment makes the existing asset better than it was when it was purchased and/or
extends its life. It is recorded as an increase in the value of the existing long-lived asset. For instance, if we add a sunroof to our car, we have improved or bettered the car, so the
cost of the sunroof is treated as an increase in the value of the car.
Betterments are not the same as repair or maintenance costs which are incurred to keep the asset in good condition and tend to re-occur at regular intervals. Repair and
maintenance costs are recorded as an expense and cannot be capitalized.
For example, the cost of changing our car's oil or performing a regular performance check-up are maintenance expenses that you pay to keep the car in good shape. They are not
costs that can be capitalized.
Accounting
You decide that Global Grocer's $56,000 reconstruction work to its warehouse should be capitalized. It has substantially increased the value of the property and you estimate that
the improvements will extend the warehouse's life to 8 years.
Let's record the improvement below. Recall that $30,000 of the $56,000 improvement is paid for in cash, and the balance is payable within one month.
The repainting work cannot be capitalized - it is a regular maintenance expense required to keep the warehouse in good working order and must be expensed when the
maintenance is performed. Maintenance expense on assets such as warehouse buildings will typically be included in line-items such as "Operating Expenses" or "General and
Administrative Expenses" on the income statement.
Let's record the $30,000 repainting transaction. Recall that we have not yet paid the painters who completed the work.
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Asset Sales
On December 1 Global Grocer bought a new van costing $28,000. Global Grocer had an old van which it sold on December 31, 2014. A restaurant owner purchased the van for
$8,000 in cash.
The van appeared on Global Grocer's balance sheet as part of the warehouse and equipment (net) line item at its acquisition cost of $10,000 net of accumulated depreciation of
$400 on November 30, 2014. The book value of the asset was therefore $9,600. One month later when you sold the van, the van's accumulated depreciation had increased to $600,
reducing the van's book value to $9,400.
You need to record the sale of the van.
Gains & Losses

When fixed assets are sold or scrapped, they must be taken off the financial statements at their recorded or "book" value. However, the book value of a fixed asset typically is not
equal to its market or "fair" value. The asset was depreciated according to a depreciation schedule; market values rarely decline in such a systematic manner and are influenced by
other forces which can even lead to an increase rather than a decrease in an asset's value.
At the time of sale, any difference between the sales price and the book value of the asset is recorded as either a gain or a loss, depending on whether the sales price is greater or
less than the book value at sale date.
Unless their magnitude is significant enough to warrant listing as a separate line item on the income statement, gains and losses on sale are generally included in the line item
"Other Income," shown below "Operating Expenses" or "General & Administrative Expenses." They cannot be reported as an extraordinary or a revenue item. Regardless of how a
gain or loss on the sale of an asset is reported in the income statement, material gains and losses must be disclosed in the notes to the financial statements.
Let's look at an example to see how to account for the disposal of an asset at a loss. Foosie Corporation owned two vehicles which it sold in 2014. The first was a two year old car,
purchased for $52,000. Here is the information concerning this asset:
Book value on date of sale: $42,400 ($52,000 - $9,600 in accumulated depreciation)
Sales price: $30,000
The loss on the sale of this asset is calculated by subtracting the book value from the sale price. In this case, there is a loss on the sale of $12,400 ($30,000 - $42,400 = -$12,400
...i.e. negative $12,400).
Let's take a look at the journal entry that would be used to record the sale.
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Foosie Corporation's other vehicle was a 1968 antique car purchased in 1995 for $1,700 and was used for roadway advertising. Here is the information concerning this asset:
Book value on date of sale: $380 ($1,700 - $1,320 in accumulated depreciation)
Sales price: $2,380
The sales price of the car is greater than its book value, leading to a gain on sale. The amount of the gain is $2,000 ($2,380 - $380 = $2,000).
Record the journal entry that would be used to record the sale.
Van
Recall that on December 31 Global Grocer sold its van for $8,000 for cash. Here is data on the cost and book value of the van:
Record the entries for the sale of the van. Once completed, you will see the updated ledger.
Intangibles
In December, Global Grocer invested $10,000 in research and development costs and obtained a patent for the formula of its newly created "Pazzazz Jam". Production of the jam
was to begin in January. Global Grocer's costs for the Pazzazz Jam were:
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As you will recall, patents are recorded as intangible assets - they meet the criteria for being an asset, but are not tangible like a factory or automobile. You wonder how to record the
costs of developing the jam prototype and the newly acquired patent.
Capitalizing
Research and development activities often result in the creation of new products which are expected to generate future revenues. However, these types of outlays are not
capitalized. The outcome of research and development is considered too uncertain to meet the definition of an asset for financial reporting purposes. As a result, the costs of these
activities cannot be capitalized and must be expensed.
In contrast, once a new product has been discovered (and the research uncertainty has been resolved), any legal costs of filing a successful patent are viewed as being an
intangible asset and are capitalized.
For Global Grocer, the only costs that can be capitalized are the legal costs of filing for the patent on the new jam formula. The employee wages and raw materials used to develop
the prototype of the new product must be expensed.
Accounting
Let's record Global Grocer's new intangible asset - the "Pazzazz Jam" patent for $4,000 - and its R&D expenses for December. Recall that the $4,000 legal and other fees related
to obtaining the patent had yet to be paid, whereas only $3,000 of the $6,000 in R&D expenses had been paid.
Let's see the journal entry and the general ledger update.
Amortization
Like fixed assets, most intangible assets are used up over time. Patents, for example, have a twenty year legal life in the US.
To reflect usage over time, for most intangible assets, a portion of their cost is written-off or amortized each period. This expense associated with this usage is called Amortization
Expense and usually estimated using the straight-line method. The amortization of intangibles is therefore very similar to the depreciation of tangible assets. However, there is
one notable difference. No contra-asset account comparable to Accumulated Depreciation is created to record the cumulative amortization of intangibles. Instead, the cumulative
amortization charge is credited directly to the intangible asset account itself.
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Exercise 9.4
On November 30, 2014, Global Grocer had a $15,750 intangible asset on its balance sheet - the franchise fee. The monthly amortization expense for the franchise fee is $750 per
month.
What is the balance of the franchise fee on the balance sheet on December 31, 2014.
Accounting
Now let's make the journal entry to record the amortization expense and update the general ledger.
Updated Financials
Let's update Global Grocer's balance sheet and income statement at December 31, 2014 for the events we have recorded this chapter related to Global Grocer's long-term assets.
Ratios
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Many businesses make sizable investments in long-lived assets. One question of interest to managers of these businesses is whether their investments in these types of assets are
productive. One metric of long-lived asset productivity is long-lived asset turnover. This ratio shows how quickly the firm is able to generate revenues from the use of long-lived
assets.
The formula for the Long-lived Asset Turnover is as follows:
Revenues
Average Long-Lived Assets
Revenues are the firm's operating revenues for the year. Average long-lived assets are the average of the beginning and end of year long-lived assets.
For example, Long-Lived Asset Turnover for a company with $75 million in revenues and total assets of $49 million at the beginning of the fiscal year and $51 million at the end of
the year would be calculated as shown below:
$75,000,000 = 1.5
(49,000,000 + 51,000,000)/2
Turnover by Industry
Long-lived asset turnover varies dramatically across industries. Some industries (such as utilities) require heavy investments whereas others (such as consulting firms) require
very little long-lived assets. These differences in long-lived asset requirements will lead to significant differences in Long-lived asset turnover across these industries.
For example, supermarkets have a very high asset turnover whereas jewelry stores tend to have a very low asset turnover.
Recap
In this chapter, you learned about tangible and intangible long-lived assets and how to account for the events that can affect long-lived assets. In particular, you learned how to:
Record the acquisition of a long-lived asset, recognizing that the asset's cost includes any outlays for delivery and installation.
Estimate and record the depreciation expense for the usage of an asset over its expected life, under either the straight-line or double-declining balance methods.
Record the disposal of a long-lived assets, including any loss or gain on disposal.
Account for the improvement of an existing long-lived asset and how to differentiate between the betterment of an asset and maintenance expense.
Identify which outlays for research and development related costs can be capitalized and which must be expensed.
Record the acquisition and usage (or amortization) of an intangible long-lived asset.
Lastly, this chapter introduced you to a new ratio - Return on Assets - which allows you to evaluate the effectiveness with which a company's manages its assets to generate
revenues and profits in the future.
Global Grocer's December 31 balance sheet and income statement, shown below, are now updated and complete.
Liabilities and Financing Costs

In this chapter you will learn more about liabilities and how to account for them. We have encountered liabilities in earlier chapters when Global Grocer borrowed from the bank. Its
liabilities under these contracts were called Short-Term Debt (used to support its general business operations) and Mortgage Payable (used to finance the purchase of its
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warehouse).
Global Grocer is facing some new challenges that arise in recording liabilities. As a result, you will learn about how to value and record future commitments under a zero coupon
loan and a lease contract, and where the amount and timing of the commitments are known. This requires understanding the concept of the time value of money and present value.*
*If after completing this chapter you feel you need more instruction on the compound interest, present value, and future value concepts, you should refer to Buying Time, a Harvard
Business School web-based online interactive tutorial.
Definition
Let's start by reviewing what you have already learned about liabilities. You learned previously that to be recorded as a liability an obligation must meet three criteria.
It involves a probable future sacrifice of economic resources by the entity.

The transfer of economic resources is to another entity.
The future sacrifice arises from a past transaction or event.
You also learned that liabilities are organized into two categories: current and non-current. Current liabilities are obligations that are expected to become due within 12 months of
the balance sheet date. Non-current liabilities are obligations that are expected to become due more than 12 months past the balance sheet date.
Examples
Here are three examples of liabilities you previously recorded on Global Grocer's August 31, 2014 balance sheet. You will notice each obligation meets the three criteria for
recognizing a liability.
At the end of each reporting period, we record interest expense for the amount of interest earned by the lender during the period. This may have been paid in advance, paid at the
end of the period or be as yet unpaid, requiring us to record a liability for the unpaid interest.
Here are some items that you did not record previously as liabilities on Global Grocer's August 31, 2014 balance sheet. You will notice each of these obligations fails to meet at
least one of the three criteria for being recorded as a liability.
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Executory Contracts
Businesses frequently enter into contracts known in law as executory contracts. These are contracts where each party has yet to perform their part of the contract. These contracts
often appear to obligate the parties. However, in general, accounting does not recognize obligations under an executory contract as liabilities.
Examples of executory contracts that do not require the recognition of a liability include the following. A law firm signs a contract to perform legal services over the next 2 years.
Since signing the contract is not performance by either party, neither the law firm nor its client would record a liability at signing. Similarly, a liability is not recorded when a
purchase order is placed with a seller to provide goods in the future.
Like many other accounting rules, there are some exceptions. You will see one of these later in this chapter.
Key Concepts
Several of the key accounting concepts that we discussed earlier, the Going Concern concept and the Conservatism concept, are particularly relevant for valuing liabilities.
Going Concern Concept
Typically, liabilities are recorded at the amount that would be required to settle them at the balance sheet date. In determining this amount, accounting assumes the liability will
be settled in the normal course of business, that is, the business is considered to be a going concern.
Conservatism
The conservation concept also plays a role in the recognition and measurement of liabilities. It suggests it is prudent to recognize liabilities as soon as reasonably possible and to
avoid understating the amount of the obligation.
Challenges
Global Grocer's business continues to be successful and a local food wholesale has agreed to distribute the company's new jam line, but there is a need to incur more liabilities to
finance its growth.
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Global Grocer is considering a zero coupon loan to finance growth
It is also planning on leasing an automatic bottle filling and capping machine to lower the cost of its manufactured jams.
One troubling development is that Global Grocer has discovered its warehouse was built near an old chemical waste dump. The warehouse land may be polluted. If this is
the case, Global Grocer faces a potential environmental clean-up cost. It may be substantial.
We are now in January. At the end of January you will have the opportunity to make the accounting entries to record these events. Updated financial statements for Global
Grocer's first year of operations reflecting these transactions and the other transactions to follow in the rest of the tutorial will be presented at the end of this tutorial.
Zero Coupon Debt

In order to fund its growth, Global Grocer is considering a type of loan known as zero coupon debt. The typical zero coupon debt arrangement is as follows: The borrower agrees
to pay the lender a fixed amount in the future in return for receiving an amount today that is less than the future payment. The borrower is also relieved from having to make
periodic interest payments to the lender.
Future Value
The financial concepts known as future value, present value and compound interest are the keys to understanding the economics and the accounting for the proposed zero
coupon loan. Let's spend a few moments reviewing these concepts, starting with the definition and mechanics of future values.
Future Value Definition:
The future value of any amount of money today is the amount that it would be worth if it were invested and grew at the specified compound interest
rate over a given time period.
Interest is said to compound when the interest earned each period continues to be invested to earn more interest.
For example, if $100 today could be invested at 10%, its future value in one year's time would be $110, comprising two parts - the initial $100 investment and one year's worth
of interest $10 (10% times $100). If it were invested at 10% for two years, its future value in two years would be $121 - again the $100 investment, $10 of interest for the first
year, and $11 interest for the second year (10% times $110, the value of the investment at the beginning of the second year).
Present Value
The present value concept uses the same logic that we used to determine the future value of an investment to compute how much an amount to be received in the future is
worth today.
The basic idea underlying the present value concept is that an amount of money available today is more valuable than the same amount received in the future. Why? Because
the money available today can grow by investing it to earn more money as time passes.
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The basic present value idea can be expressed more formally by the following definition.
Present Value Definition:
The present value of an amount to be received at a specified future date is the investment that we would need to make today that, with the benefit of
compound interest, would grow to the same amount as the future amount to be received at the future date.
For example, assuming a 10% interest rate, $110 to be received in one year's time would be worth only $100 today. If we invested the $100 today at 10%, we would have exactly
$110 in one year. We would therefore be indifferent between the two. Similarly, $121 in two years time would be worth $100 today, since $100 invested for two years at 10%
would grow to $121.
Exercise 10.1
Impact of Changes in Interest Rates and Investment Horizons on Future Value of Investing $1000 Today
Assume you invest $1000 today. If you receive interest at an annual rate of 10%, the investment is worth $1,100 in one year's time.
Move your mouse over the cells in the table on the right that correspond to an interest rate/investment horizon combination to see how the value of your investment changes.
How does the value change as you increase the investment horizon? What happens if you keep the investment horizon fixed and increase the interest rate?
Year 0 Year 1 Year 5 Year 10

0% $1000 $1000 $1000 $1000
5% $1000 $1050 $1276.10 $1628.89
10% $1000 $1100 $1610.51 $2593.74
15% $1000 $1150 $2011.36 $4045.56
Impact of Changes in Interest Rates and Investment Horizons on Present Value of Receiving $1000 in Future
Assume you receive $1000 in one year's time. If you can earn interest at an annual rate of 10%, the present value of the $1,000 is $909.
Move your mouse over the cells in the table on the right that correspond to an interest rate/timing of receipt of the $1000 combination to see how the present value changes.
What happens as you increase the years before the amount is received? What happens if you keep the years till receipt fixed and increase the interest rate?
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$1000 $1000 $1000 $1000
$1000 $952.38 $783.53 $613.91
$1000 $909.09 $620.92 $385.54
$1000 $869.57 $497.18 $247.18
Equations
We will briefly review the formulas that are used to calculate future and present values. As you will see in a moment, in practice you will use tables, calculators or computers to
generate these calculations.
Here is the formula used to calculate the future value (F) of an amount P that is invested today for n periods at an interest rate i:
F = P(1 + i)n
Where:
F = Future Value
P = Initial Investment
i = Interest Rate
n= Number of Periods
Using the above present value equation, what is the future value at the end of 3 years of $1,000 invested at 20% today?
The formula used to calculate the present value (P) of an amount F that is to be received in n periods time when the interest rate is i:
P= F
(1 + i)n
Where:
P = Present Value
F = Future amount received
i = Discount rate
n= Number of years to receipt of future amount
Using the above future value equation, what is the present value at the end of 3 years of $1,000 invested at 20% today?
Present Value Tables
Many accounting, finance and economics textbooks include tables that give the present value of a dollar received sometime in the future. Your briefcase includes a complete
present value table.
Let's see how to use these tables. The table shows that the present value of $1 to be received in two years time assuming a compound interest rate of 10% is 0.826. This implies
that if we invested $0.826 for two years at 10% our initial investment would grow to $1 (allowing for some rounding error).
Exercise 10.2
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Using the present value table, what is the approximate present value of $1,332 to be received in 3 years time given an interest rate of 10% per year?
Semi-annual compounding
Sometimes lenders require that interest compounds semi-annually, not annually. How do we reflect this in our calculations? What impact does it have on present values?
Let's take a look at what happens using our previous exercise, where we receive $1,332 in 3 years time, and interest rates are 10%. If interest compounds semi-annually, our
10% annual rate is equivalent to a 5% semi-annual rate, and the three years are equivalent to 6 half-years.
Using the present value tables, the present value factor in the 5% interest/6 periods cell is 0.746. The present value of $1,332 to be received in 3 years time given an interest rate
of 10% with semi-annual compounding is therefore:
$1,332 * 0.746 = $944
You can confirm that this answer is correct by calculating the present value of investing $994 for 6 periods at 5% interest.
Note that the present value of $1,332 for 6 half-years at 5% ($994) is less than the present value of the same amount for 3 years at 10% ($1,000). The reason is that with semi-
annual compounding we are able to generate more interest from our investment since we begin earning interest on our interest every six months rather than every year.
Exercise 10.3
You are given the following alternative: Accept $1,000 today or receive $1,100 in three years time. You can deposit monies in your savings account and earn 4% annual interest
over the next 3-years. Which alternative would you choose?
Loan Value
Now that you understand how future and present values work, you are ready to value the zero coupon loan being considered by Global Grocer. Recall that Global Grocer is
reviewing a 2-year $100,006 zero coupon loan. Under this arrangement, Global Grocer will receive $82,650 at the loan inception, and pay the lender $100,006 in two years
time when the loan matures. Although Global Grocer will not make any interest payments during the loan's term, the lender expects to earn 10% interest on the loan. The
lender is able to achieve this by paying only $82,650 to Global Grocer at the loan inception and receiving $100,006 at the end of the two year loan term. The difference of
$17,356 is implicit interest on the loan. Global Grocer is attracted to the zero coupon loan opportunity because this deferral of interest payments will reduce the cash it needs to
pay the creditor in the short-run.
Notice that the loan terms reflect both the future value and the present value concepts. If we invested $82,650 at 10% for two years, we would generate $100,006, the loan
payment. In other words, $100,006 is the future value of the initial loan amount of $82,650.
Alternatively, the loan amount of $82,650 is the present value of the loan payment of $100,006 in two years assuming a 10% interest rate. You can check this by referring to the
present value tables. The present value of $1 to be received in 2 years at 10% is 0.826. The present value of the final payment to the creditor is therefore $100,006*0.826 or
$82,605.
Accounting
Now, let's consider the accounting for Global Grocer's zero coupon loan. To do so, we will have to answer two questions:
What amount should be recorded as the liability - the discounted amount received or the higher maturity amount?
Since there is not a periodic cash interest payment, what periodic interest expense, if any, should be recorded?
Initially, zero coupon loans are recorded as a liability at the amount received. Then, in each subsequent accounting period, interest is accrued at the rate implied by the
arrangement. The accrued interest is recorded as an expense and an addition to the loan liability balance. The interest accrual reflects the fact you have had the use of the
creditor's money, which in turn creates a future obligation. The recording of the interest ensures that the cost of the loan is reflected in the period that the loan was used.
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To illustrate how accounting works for a zero coupon loan, let's consider the loan advanced to East Corporation. East borrows $79,700 under a zero coupon loan and is
obligated to pay the lender $99,975 at the end of two years. The loan has been priced by the lender to earn an annual 12 per cent return, which, from East's point of view, is the
loan's interest rate.
Zero Coupon Loan Entry

Global Grocer decided to accept the zero coupon loan offer. At the end of January, Global Grocer signed the $100,006 zero coupon loan agreement and received $82,650.
Complete the January 31 journal entry to record Global Grocer's zero coupon loan obligation. Do this by dragging the correct accounts and amounts to the appropriate places
on the journal. Once this is correct, the General Ledger will appear. Then drag the amounts to the appropriate places in the ledger.
Leases
Global Grocer's manufactured jams are proving to be very popular. To speed up their production and to reduce labor costs, Global Grocer decides to acquire an automatic bottling
and capping machine. In order to conserve cash, Global Grocer intends to lease rather than buy the new machine.
A lease grants the lessee, in this case Global Grocer, the use of property for a specified time in exchange for a series of periodic rental payments to the owner of the leased
property. The owner of the leased property is called the lessor.
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Introduction
For legal purposes, leases are executory contracts. Normally, as noted earlier, accounting does not recognize executory contract obligations as liabilities. But some leases are an
exception.
Even though the lessor is the legal owner of the leased asset, depending on the terms of the lease, the lease obligation may be recorded by the lessee as a liability and the leased
asset as an asset. This lessee accounting treatment is required when the lease arrangement is in substance equivalent to an asset purchase. Accountants refer to these in
substance purchase-type leases as capital leases. All other leases are called operating leases.
The challenge now facing you is to determine if Global Grocer's machine lease is a capital or an operating lease for accounting purposes.
Capital Lease Accounting

Because of the ownership-like nature of the lessee's rights to use the leased asset, capital lease accounting assumes the lessee has in substance financed the acquisition of the
right to use the leased asset with an installment loan. Consequently, the lessee records initially the present value of the lease payments as a liability along with an asset in the
same amount. Subsequently, the leased asset is depreciated like any similar owned asset and the liability is accounted for as an installment loan.
A Capital Lease in substance is an:
Asset Purchase
Installment Loan Financing
GAAP Capital Lease Criteria
Under GAAP, a lease arrangement is classified as a capital lease if one of the following criteria are met:
Ownership of the leased asset is transferred to the lessee at the end of the lease term.
The lessee has an option to purchase the leased asset at a bargain purchase price.
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The term of the lease is 75 percent or more of the leased asset's economic life (i.e., its productive life).
The present value of the lease payments discounted by the lessee's borrowing cost is 90 percent or more of the fair value of the property.
For the purpose of applying these tests, the lease term includes renewal options.
The particular depreciation method applied to the leased asset depends on the basis for classifying the lease as a capital lease. If the capital lease classification is based on the
lease meeting either the 75 percent or 90 percent test, the asset is depreciated over the lease term and salvage value is not considered. In contrast, if the capital lease
classification is based on the lease meeting either the bargain purchase or ownership transfer test, the asset is depreciated over its useful life to the lessee and salvage value is
considered. The useful life may be longer than the lease term. If a capital lease classification could be based on either the bargain purchase of ownership transfer test and one
or both of the other two tests, the bargain purchase and transfer ownership test depreciation method is applied.
Exercise 10.4
Satisfying which one of the following tests does not require classification of a lease arrangement as a capital lease:
IFRS Capital Lease Criteria

Risks and Rewards of Ownership
Under GAAP and IFRS, the accounting entries for a lease classified as a capital lease are the same. The difference between the two standards lies in the tests used to identify
capital leases.
The tests for a capital lease listed on the previous slide are GAAP. This standard is referred to as a "rule-based" or "bright-line" accounting standard. In contrast, IFRS's
capital lease accounting standard is "principle-based" accounting standard. IFRS stipulates that if substantially all the "risks and rewards incident to ownership" lie with the
lessee, the lease is a capital lease. Otherwise, it is an "operating lease."
Exercise 10.5
Under IFRS, leases that substantially transfer to the lessee the "risks and rewards" incidental to ownership are capital leases. Three of the following four lease agreement
terms transfer the risks and rewards of ownership to the lessee. Which lease term does not transfer the risks and rewards of ownership to the lessee?
Present Value
The present value concept we used to value and record a zero coupon loan is also critical to understanding the economics of capital leases, determining whether a lease
should be recorded as a capital lease, and valuing capital lease assets and liabilities.
The lease payments that the lessee promises in the future can be valued today by taking their present values and summing them up.
For example, consider a personal computer lease agreement for two years under which the lessee makes lease payments of $1,000 today and $1,000 in one year's time. If the
lease qualifies as a capital lease, the lessee is effectively borrowing to finance the use of the personal computer for two years. Assuming the interest rate used for the lease is
10%, the present value of the lease payments is $1,909:
Annuity
A lease agreement typically involves making identical payments each year for a specified period. This is called an annuity. Many textbooks include an annuity table that
shows the present value of an annuity of one dollar payments for different periods and interest rates. This table is helpful for calculating good approximations of the
present value of a stream of constant annual payments, such as lease rentals.
Annuity tables are read in the same manner as present value tables. For example, to find the present value of an annuity of $1 a year for 5 years discounted at 12 per cent,
read across the 5 year line until it intersects with the 12 per cent column. The 3.605 factor at this point indicates the present value of the annuity is $3.605.
Once you know the present value of a stream of one dollar payments, it is simple to calculate the present value of any stream of constant dollar amounts. For example, if a 5
year lease agreement called for 5 annual $1,000 lease payments, the present value of this stream of payments discounted at 12 per cent is $3,605 ($1,000 * 3.605).
Below is a portion of the annuity table. This tutorial's briefcase includes an expanded annuity table.
Exercise 10.6
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Using the above annuity present value table, what is the present value of a 4-year stream of annual $1,000 payments discounted at 6 percent?
Illustration
To illustrate the accounting for a capital lease of a piece of machinery, assume the following: The lease meets the 75% capitalization test; the lease term is 3 years; the annual
rental is $3,000; the lessee uses straight line depreciation; and, the lessee can borrow money at a 10 percent interest rate.
Beginning with the next page, you will see the key role present value mathematics plays in accounting for capital leases.
Present Value Calculation

The first step in accounting for this capital lease is to calculate the present value of the lease payments. This amount will be the initial amount recorded for the capital lease
related liability and asset.
Alternatively, we could calculate the present value by summing up the present value of each payment as follows:
Record Capital Lease Liability

Once we know the present value of the lease payments, we can record the value of the leased asset and liability.
Let's look at the initial journal entries and the transfer of the journal entries to the ledger accounts
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Capital Lease Payments

The second step in accounting for the illustration capital lease is to generate the capital lease obligation amortization schedule and related journal entries. Remember
accounting views this obligation as being similar to an installment loan. Therefore, each rental payment will consist of two components. Namely, a 10% interest payment
on the outstanding balance of the loan and a repayment of part of the loan's outstanding balance.
Below is the capital lease obligation amortization schedule and the related journal entries.
Capital Lease Asset Depreciation

The last step in accounting for the illustration capital lease is to generate the depreciation schedule and related journal entries for the leased asset. The depreciation
schedule follows the company's straight-line depreciation policy. The annual depreciation is calculated using the three year lease term. Since the leased asset must be
returned to the lessor at the end of the lease, it does not have any residual value to the lessee.
Below is the annual depreciation schedule and the related journal entries.
Operating Lease Accounting

If a lease is not a capital lease, it is classified as an operating lease. The accounting for an operating lease is straightforward. The periodic lease payments are simply recorded as
a lease expense each year. Neither a liability nor an asset is recognized.
To illustrate operating lease accounting, assume you leased a new car for 3 years for an annual rental payment of $3,000 under an operating lease.
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Exercise 10.7
You have made the first year lease rental payment. What are the first year journal entries for a 3 year operating lease requiring an annual lease rental payment of $6,000?
Global Grocer Lease

Now, let's turn to your Global Grocer lease accounting decision (you may want to review the "Capital Lease Criteria" screen before proceeding to analyze the terms of the Global
Grocer lease agreement).
The leased machinery was delivered and installed by the lessor on January 31. Over the prior week, you learned the following about the proposed machinery lease.
You have to decide whether the lease satisfies the criteria for a capital lease, or whether it is an operating lease. What is your decision?
Watch the video for the correct answer.
The lease is a capital lease. The lease term (5 years) is more than 75% of the leased assets economic life (6 years). 5/6 = 83.3%
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Having decided the Global Grocer lease is a capital lease, you must now prepare the related journal entries. Your first step is to determine the present value of the leases' five
$5,000 annual rental payments using Global Grocers' 10 per cent borrowing rate.
Use the annuity table to make your calculation.
Enter your calculated present value amount here:
Initial Entry
Now that you have determined that the present value of the 5-year stream of annual $5,000 lease payments to be made by Global Grocer is $18,955, you can make the
January 31 journal entry to record Global Grocer's capital lease obligation and asset.
Balance Sheet Effect

The next step in your initial accounting for the capital lease is to display the capital lease obligation correctly in the January 31 balance sheet.
Since the capital lease obligation is viewed as a form of debt, when the obligation is displayed in the balance sheet it must be presented in two parts. The next year's principal
reduction portion in the next annual lease payment is shown as a current liability in the current period's balance sheet. The obligation remaining after the current portion is
deducted from the total end-of-period obligation and is reported as a non-current liability.
Current vs Non-Current
To determine Global Grocers' current vs non-current balance sheet presentation of the initial capital lease obligation you prepared the first two years of its five year lease
obligation amortization schedule shown below.
The first line of the amortization schedule indicates $1,896 of the first annual $5,000 lease payment is interest on the initial $18,955 lease obligation. The remaining $3,104
of this $5,000 lease payment represents a reduction of the lease obligation. That is, $3,104 of the $18,955 initial valuation of the capital lease obligation will be returned as
part of the $5,000 lease payment to the lessor when the first annual lease payment is made. Accordingly, when the capital lease obligation is displayed in the January 31
balance sheet, $3,104 will be listed as a current liability since it will be paid within the next 12 months. The $15,851 remaining balance of the obligation will be reported as a
non current liability.
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Contingent Liabilities
As noted earlier, in January Global Grocer discovers that its warehouse was built near an old chemical waste dump. The warehouse land may be polluted. If this is the case, Global
Grocer faces a potential environmental clean-up cost. It may be substantial.
Accountants refer to the potential chemical waste cleanup cost as a loss contingency. That is, the obligation involves uncertainty as to the possible cost which will only be resolved
by some future event that may or may not happen.
The Global Grocer and you now face a different accounting challenge: Should this loss contingency be recognized as a liability?
Required Conditions
The determination of whether or not a loss contingency should be recorded as a liability requires judgment.
A loss contingency is recognized as a liability when both of the following conditions are met.
Information available prior to the issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred (That
is, the three liability criteria have been met).
The amount of the loss can be reasonably estimated.
Future Events
Implicit in the first required condition for recognition is that it must be probable that a future event will occur confirming the fact of the loss. In making this judgment,
accountants recognize the likelihood of the future event that will confirm the loss has occurred can range from probable to remote.
As noted earlier, in order to recognize a loss contingency as a liability, it must be probable that the future confirming event or events will occur. That is, the future event or
events are likely to occur.
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Exercise 10.8
The East Company's glass division had a contract to install all of the windows in a new 50-story see-through office building. The building's completion date was delayed for
nearly a year due to problems associated with the installation of the windows. Eventually, the building owners sued East for $10 million claiming loss of rental revenues.
Concurrently, East's lawyer recommended East settle the litigation. Any settlement would not be reimbursed by insurance.
When should East record a liability for the loss contingency arising from the defective window installations?
Accounting
To illustrate the accounting recognition of a loss contingent assume the following: The Allen Company reaches the conclusion that a $100,000 litigation loss contingency
should be recognized as a liability and a current expense. Subsequently, one year later the litigation is resolved and the actual cash litigation loss is $70,000, rather than the
original estimated $100,000.
Let's now record the journal entry for these events.
Global Grocer
It is now January 31 and you have to decide whether or not to record a contingent liability for Global Grocer's possible chemical waste cleanup cost.
So far you have gathered the following facts:
The potential source of any contamination of the warehouse property is located nearly a half mile away.
The degree of contamination of the potential source is still under investigation.
It is believed, but it is not confirmed, that ground water flows from the contamination site in the general direction of the warehouse property.
A local environmental cleanup company has estimated that, depending on the extent of contamination; the cost of cleaning up the warehouse property might range
from $30,000 to $70,000. Insurance would not cover any of this cost.
What is your decision? Should Global Grocer record a chemical waste cleanup cost liability on January 31? (Decide on your answer before going to the next screen).
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Accounting Decision
Note Disclosure
Global Grocer has decided to follow the majority's accounting and disclosure loss contingency decision. The above note will be included as part of the company's January 31,
2015, financial statement presentation.
IFRS
IFRS refers to those contingent liabilities that GAAP recognizes on the balance sheet as "provisions," not "contingent liabilities." The term "contingent liability" is reserved to
describe those unrecognized contingent liabilities that under GAAP and IFRS may or may not have to be disclosed.
Debt Ratings
The investment quality of the debt of companies may be rated by debt-rating services. For example, Moody's, a leading debt rating service, issues ratings that are expressed in
terms such as AAA (the highest rating) all the way down to C (the lowest rating). The rating represents the likelihood the debtor will pay the debt's principal and interest on time.
For the most part, the higher the debt rating, the lower is the required rate of return of investors. Debt rated triple B or better is considered to be of "investment grade." It is
considered to be a relatively safe investment. An investment grade rating is considered desirable since many financial institutions by regulation or policy cannot hold debt rated
less than investment grade. Many unrated and less than investment grade debt are referred to as "junk bonds."
Interest Coverage Ratio

EBITDA Coverage Ratio = EBITDA
Total interest charges
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Rating services use many of the ratios you have reviewed in earlier chapters to reach their rating decision. In addition to these ratios, an extremely important class of ratios
known as interest coverage ratios is employed. These ratios are designed to measure how adequately creditors are protected by funds generated by the debtor's operations. One
of the most popular interest coverage ratios is shown above. The numerator of this ratio is referred to as a company's "EBITDA." Generally, the higher the EBITDA coverage
ratio, the higher is a company's debt rating.
Examples
Global Grocer's EBITDA

Global Grocer's December 31 income statement and its accompanying Depreciation and Amortization note are shown below. What is Global Grocer's December EBITDA to
total interest ratio?
Use your mouse to identify one-by-one the line items in the income statement and note that you will use to compute Global Grocer's December EBITDA to total interest ratio.
Recap
This chapter has extended your knowledge of accounting for liabilities. In particular you learned
Generally, executory contracts do not give rise to liabilities, but there are some exceptions.
Zero coupon debt is initially recognized as a liability at the amount received by the borrower. Over its life, the interest on zero coupon debt is accrued as a non-cash
expense and as an addition to the related liability.
Leases are classified as either capital or operating leases. Capital leases are accounted for as if they are a purchase of an asset financed by an installment loan.
Operating lease rentals are an operating expense. Neither an asset or a liability is recorded by the lessee.
Loss contingencies are recorded as a liability when 1) it is probably that an asset has been impaired or a liability has been incurred, and 2) the amount of the loss can
be reasonably estimated. Gain contingencies are not recognized until realized.
EBITDA interest coverage ratio measures a borrower's ability to meet interest payments from operating funds.
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Investments and Investment Income

In this chapter, you will learn about how to account for investments in other companies and to record investment income. Key management challenges you will cover include the
following:
How to record the acquisition of short-term investments in stocks and bonds that have been purchased as an alternative to holding cash at the bank
How to record gains and losses on different types of short-term investments
How to record a long-term investment that results in the acquirer gaining control over the other company and integrating the two businesses
As in previous chapters, you will learn the accounting for these types of transactions by doing the accounting for Global Grocer.
Challenges
As Global Grocer enters the end of its first six months of operations, you encounter the following new reporting challenges relating to investments in other companies:
$15,000 of excess cash, which had been put into marketable securities, had increased in value to $16,500. How should the investment be valued in the balance sheet?
Should any gain on the investment be reflected in the income statement?
You decide to acquire one of your competitors, International Specialties for $$1,184,350. In its own books, International Specialties values its equity at $224,435. How
should the acquisition be recorded?
Several factors affect the way that these transactions are recorded: the motivations for undertaking the investment in the first place, and the extent to which we have control
over the firm in which we have invested.
Investment Motivations
Firms acquire the debt and equity securities of other firms for a variety of reasons.
They may use these types of investments as a convenient way to park excess cash needed to fund working capital or long-term assets in the near future. Investing in
other company debt or equity is expected to provide a higher return than could be earned by keeping the excess cash in the bank.
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Managers also make investments in other companies for strategic purposes. These types of investments typically involve acquisition of a majority of the equity of
another company. The acquiring company's management then has control over the acquired company, enabling it integrate it into its own operations or to take other
actions that improve the performance of the newly-created combined firm.
Since the motivation for these types of transactions is very different, we record the two very differently.
Control
Accounting distinguishes between investments that enable one firm to control another, and investments where there is no such transfer of control. One firm controls another if
it owns a majority (i.e. more than 50%) of its common equity. As noted above, managers typically view controlling investments as long-term and strategic. These types of
investments are called business acquisitions or combinations and are accounted for using the purchase method.
In contrast, there is no issue of control when a firm acquires only a small percentage of the common equity of another firm. Investments in corporate debt or equity stakes of
less than 20% are usually viewed as not involving control. These types of investments arise when a firm is using the investment as a convenient temporary place to park excess
cash. These investments are called marketable securities and are accounted for using either the cost or market method.
Investments in the equity of another company that are 20% or more, but less than majority ownership are likely to provide the acquiring firm with some in-between level of
control. These types of investments are called equity investments or investments in associated companies and accounted for using the equity method. Discussion of
these types of investments is beyond the scope of this chapter.
Marketable Securities
Marketable Securities are shown as current assets on the balance sheet. They are investments that are
Readily marketable
Expected to be converted to cash within a year
Have no control implications for the company whose securities are acquired
Popular marketable security investments include commercial paper and treasury bills. Commercial paper is the name given to a type of short-term interest bearing note issued
by corporations. Treasury bills are interest paying short-term obligations sold by the U.S. Treasury. Other forms of marketable securities include the marketable common stock
of other companies, corporate promissory notes and corporate bonds.
Investments that are not marketable or that are going to be held for longer than a year, but which do not provide the owner with any control rights, are listed as long-term
investments rather than marketable securities on the balance sheet. These investments are accounted for at their cost.
Exercise 11.1
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Which one of the following readily marketable securities is not a marketable security for accounting purposes?
Intent
As noted earlier, marketable securities are recorded using either the cost or market methods. The investment intention of the investor in acquiring marketable securities
determines which of these methods is used. Therefore, the first step in the marketable security accounting decision is to determine the investor's intent.
Accounting classifies an investor's intent in one of the following three categories. They are:
Hold-to-maturity
Trading
Available-for-sale
Hold-to-Maturity
Hold-to-maturity marketable securities are debt securities that the investor intends to hold to maturity. These types of marketable securities are accounted for on the balance
sheet at their cost.
Trading
Trading securities are debt and equity securities that the holder intends to sell in the near term as part of a plan to earn profits from short-term movements in the security's
price.
Trading securities are accounted for at their market value. That is, at each balance sheet date they are reported at their current market value. Any unrealized gain or loss since
the last balance sheet date is included in the income statement as investment income. When the security is eventually sold, any additional gains or loss is also recorded in the
income statement as investment income.
For example, consider an equity security bought near the end of the month for $1,000. The intent is to profit from a short-term upward movement in its price. At the end of
the month, when the company prepares its financial statements, the security is still owned but its market price has increased to $1,100. Two-days into the next month the
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security is sold for $1,050.
Since the investor intends to profit from a short-term movement in the security's price, the investment is classified as a trading security.
The Unrealized Gain of $100 and Loss on Sale of $50 are included in the income statement for the appropriate period as part of Investment Income.
Available-for-Sale
Available-for-sale securities are debt and equity securities that do not fall into either the hold-to-maturity or trading security categories.
Like trading securities, available-for-sale securities are reported on the balance sheet at their market value. However, unlike the case of trading securities, unrealized gains
and losses on available-for-sale securities are not shown as Investment Income. Instead they are directly credited/debited to a special shareholders' equity account called
Unrealized gains and losses on Available-for-Sale Securities. When the security is sold and an actual gain or loss is realized, any related unrealized gain or loss
recognized to date is eliminated from owners' equity and the actual gain or loss is recorded in the income statement.
Let's see how this works in practice. Consider the following example. A company acquires securities that are available for sale for $50,000 at the beginning of the month. At
the end of month the securities had a market value of $52,300. During the following month the securities were sold for $54,000, a realized a gain of $4,000 over the original
cost of the securities.
At the end of the purchase month, the Unrealized gain on Available-for-Sale Securities of $2,300 is included in the balance sheet as part of Shareholder's Equity. When the
securities are sold in the following month, the debit to Unrealized gain on Available-for-Sale Securities of $2,300 eliminates this account in the Owners' Equity segment of
the balance sheet. The realized Gain on Sale of Available-for-Sale Securities is shown on the sale month income statement as part of Investment Income.
Exercise 11.2
Which statement is false?
Global Grocer
Let's record the transactions involving marketable securities for Global Grocer.
Global Grocer invested $15,000 of excess cash in the common stock of a large well-traded public company at the beginning of February. It anticipated that this investment
would generate a higher return than would be earned by investing in the bank. However, it did not intend speculating on short-term movements in the stock's price. At the
end of the year, the stock was valued at $16,500.
How should this investment be recorded?
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How would these marketable securities be classified based on Global Grocer's intensions?
What is the journal entry to record the purchase of the stock for $15,000?
Business Acquisitions
A business acquisition is a transaction where one entity gains control over the assets and operations of another. Late in the year, you become aware that the owner of
International Specialties, a competing business, is considering retiring and is interested in selling her business to you.
Purchase Price
You hire a broker to help you to determine what International Specialties is worth. After reviewing the following last annual financial statements for the company, the broker
suggests that you propose acquiring the business for $1,184,350 and finance the acquisition using a long-term bank loan.
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Accounting
Business acquisitions are recorded using the acquisition method of accounting. Under this method, the acquiring company records on its balance sheet the fair value of the
net assets (that is the assets net of any liabilities) that it acquires. Fair value is the amount a willing buyer and seller would exchange for an asset or liability in a current
transaction, other than a forced or liquidation sale.
If the purchase price is greater than the fair value of the net assets acquired, the excess purchase price is recorded as an asset called goodwill, and is reported as an intangible
asset on the balance sheet. Net assets acquired is the difference between the value of the acquired assets excluding any goodwill and the value of the acquired liabilities.
Purchase Price = Fair value of assets acquired + Fair value of liabilities assumed + Goodwill
Net Assets Fair Value

Among the financial information provided by the business broker you hired to help value International Specialties is an estimate of the fair values of the firm's assets.
Calculating Goodwill
If Global Grocer bought International's assets listed on the previous screen (fair value $711,400) as well as its continuing business for $1,184,350 and, in addition, assumed
International's liabilities (fair value $233,050), how much would Global Grocer record as goodwill?
Is your calculated goodwill amount an asset or a liability?
Interpreting Goodwill
Goodwill is a common balance sheet account. Working from the everyday dictionary definition of goodwill, it reflects the value of a company's intellectual capital, product
strength, good reputation and other valuable intangible attributes of the acquired company. It is important to recognize that goodwill only appears on the balance sheet when
a company purchases another company for more than the fair value of its net assets. Based on the acquirers' purchase price, goodwill can be thought of representing the value
of the acquired company's earning power in excess of the earning power of the acquired net assets standing alone.
As noted earlier, goodwill is an intangible asset. However, the accounting for goodwill differs from that of most other intangibles since it is not amortized. Instead, it is tested
annually for impairment and, if impaired, the decline in the value of the asset is reflected on the balance sheet and an expense for the amount of the impairment appears on
the income statement.
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Recording Acquisition
You arrange for a long-term bank loan to finance the acquisition of International Specialties. The owner agrees to your offer and the transaction is completed in early March.
Let's prepare the journal entry to record Global Grocer's acquisition of International Specialties.
Income Effects
How will acquiring International Specialties affect Global Grocer's future earnings? Since the two firms are now viewed as a combined entity, the income statement for the
new firm going forward will include the revenues, cost of sales, and other expenses of both firms together.
In addition, as discussed above, each year Global Grocer will estimate the fair value of the goodwill related to the International Specialties acquisition. If the asset is impaired,
it will have to record an expense for the write-down, and reduce the asset's value on its balance sheet.
Exercise 11.3
Verity Greeting Cards has offered to acquire Friendly Faces Cards for $2,300,000, payable in Verity Greeting Cards common stock. Friendly Face's assets and liabilities are
as follows:
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What value will Verity Greeting Cards place on goodwill?
Prepare the journal entry to record Verity Greeting Cards acquisition of Friendly Faces Cards for $2,300,000 in stock. Friendly Face's assets and liabilities are as follows:
Recap
In this chapter you covered how to record the acquisition and income from investments. You learned that
Marketable securities are short-term investments in debt or equity securities that a firm uses as an alternative to depositing surplus cash in the bank.
Marketable securities must be classified in one of three categories, depending on the intent of the investing firm. The accounting for each category is different.
Business combinations arise when one firm acquires more than 50% of the common stock of another firm.
Business combinations are accounted for using the acquisition method, which values the assets acquired and liabilities assumed at their estimated fair values.
Any difference between the purchase price for a business acquisition and the fair value of the net assets other than goodwill is recorded as a goodwill asset on the
acquirer's balance sheet. Goodwill is not amortized, but is reviewed for impairment each year and, if impaired, written down through a charge to earnings to its new fair
value.
Since the motivation for each of the types of investments discussed in this chapter are very different, we account for them differently.
Deferred Taxes and Tax Expense

In this chapter you will learn about accounting for income taxes. In particular, you will learn
That the methods used to prepare a firm's taxable income and estimate the taxes that it owes the government can differ from those used to prepare the financial reports
used by managers and investors to evaluate performance.
That differences in a firm's pre-tax earnings for tax and financial reporting purposes can give rise to a deferred tax liability or deferred tax asset, an accrual that appears on
the balance sheet.
How to record the tax expense in the income statement and any deferred tax asset or liability balance sheet accounts to reflect any differences in tax and financial
reporting accounting.
As in previous chapters, you will learn the accounting for these types of transactions by doing the accounting for Global Grocer.
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Management Challenges
Global Grocer is concluding its first year of operation. You realize that you have to prepare a tax return to determine the amount of taxes that the firm owes the government. To
help you with this task you hire a tax accountant who informs you that taxable earnings on your tax return will be different than the earnings before tax amount shown in the
financial statements you have already prepared. This difference arises because the accounting methods for recording transactions used for tax reporting are not always the
same as those used for financial reporting.
As you reflect on your conversation with the tax accountant you wonder how you should record taxes in Global Grocer's financial statements. How, if at all, should differences
between the accounting methods used to compute earnings for the tax authority and for financial reporting be recorded in Global Grocer's books?
Tax vs Financial Reporting

In many countries the accounting methods that the government requires or allows companies to use for tax return preparation differ from those used for financial reporting
purposes.
Governments have different objectives and information needs than a firm's investors. For example, the government often permits firms to use shorter economic lives and more
accelerated depreciation of new equipment for tax purposes to meet its economic goals of encouraging investment in new capital and creating additional employment.
Governments put a premium on objectivity in measuring taxable income whereas, as we have seen, investors value the relevance of information. As a result, governments often
disallow tax deductions for expenses that are estimates of future losses, such as estimated bad debt expenses. Instead, these losses are reported for tax purposes when a loss has
actually occurred.
The differences in methods used to report income for tax purposes and for financial reporting lead many firms to effectively have two different sets of accounting records - their
tax accounting records (sometimes referred to as "Tax Books") and their financial reporting records (sometimes referred to as "Financial Reporting Books").
Example
To understand how differences between tax and financial reporting books arise, let's look at a simple example.
Pascoe Inc., which has earnings before depreciation of $2,000 for financial reporting and tax purposes in years 1 and 2, buys a 2-year depreciable asset at the beginning of
year 1 for $1,000. For financial reporting purposes the asset is depreciated using the straight line method (at $500 per year). For tax return purposes, Pascoe takes the entire
$1,000 purchase price as a tax deduction in the acquisition year. Pascoe pays taxes on its taxable income at a 40% tax rate. Its tax return and income statement in the
financial reporting books would look as follows:
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Tax Expense vs Taxes Due

It would be convenient to simply show the tax expense in the financial reporting books as the amount the company owes the government based on its tax return. For the Pascoe
Inc. example, this would imply that the Income Tax Expense would be $400 and $800 in years 1 and 2.
Under this approach, the income statement in Pascoe's financial reporting books would show earnings before taxes based on the financial reporting accounting methods and
the tax expense based on the methods used for the tax books.
However, standard setters have concluded that this presents a misleading picture of the company's financial performance for the two annual periods. Pascoe's net income in
year's 1 and 2 would be $1,110 and $700 respectively. These amounts differ even though income before taxes is identical at $1,500 in both years. In addition, year 1's net income
would be a misleading indicator of net income in year 2, since the firm's operating performance does not change.
Deferred Tax Accruals

How then should we record the tax expense? In particular, what should we do to reflect the effect of differences in accounting methods used in the firm's financial reporting and
tax books?
Standard setters have dealt with these accounting differences by requiring that the tax expense be based on Income Before Taxes in the financial reporting books rather than
Taxable Income in the tax books. This leads to the creation of a deferred tax accrual to reflect the tax effect of any accounting method differences that exist between the two sets
of books. As you will learn, the accounting effect of most of these accounting differences reverse in some future period. Consequently, accountants refer to these accounting
differences as "temporary accounting differences".
The deferred tax accrual is consistent with the matching concept since it matches the tax expense in each year with Income Before Taxes in the financial reporting books. The
tax accrual can appear as a liability or an asset on the firm's balance sheet.
Financial Reporting Books

- Tax Books
= Temporary Accounting Differences
X Tax Rate
= Deferred Tax Accrual
Timing Differences
Deferred tax accounting is used when the following three conditions hold:
A transaction or event is accounted for differently in an entity's financial reports and income tax returns.
The accounting effect of the difference in accounting policies is temporary in that the early period effects of the difference are reversed in later periods.
The accounting difference has tax consequences.
When these conditions hold there is a difference in the timing of financial reporting and taxable income.
Let's return to the example of Pascoe Inc., which used accelerated depreciation for its tax books and straight-line depreciation for its financial reporting books. We can see
that the depreciation difference meets all three of the above conditions required for using deferred tax accounting.
The accelerated depreciation method leads to higher depreciation charges than the straight-line method in the early years of an asset's life, resulting in a lower taxable
income in those years.
The effect is temporary since at some point in the asset's depreciable life the accounting effect of the two depreciation methods reverses. This occurs in the later years
of the asset's depreciable life when financial reporting straight-line depreciation charges are higher than the tax return accelerated depreciation charges.
The difference in the use of the two depreciation methods has tax consequences. The higher early year tax deductions for depreciation lead to lower taxable income
than if the company used straight-line depreciation for tax return purposes. In the later years of the asset's depreciable life this situation is reversed.
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Permanent Differences
Not all differences between financial and tax return accounting result in the recognition of a deferred tax accrual. These exceptions occur when there is a permanent rather
than a temporary difference between a company's financial and tax accounting. Permanent differences occur when either revenue or expenses are recognized for tax return
purposes but never for financial reporting purposes or expenses or revenues are recognized for financial reporting purposes but never for tax return purposes. In other
words, permanent differences are accounting differences that do not reverse in future periods.
Exercise 12.1
Is the following statement true or false: A retail company is required by GAAP to recognize for financial reporting purposes the full profit on its installment sales when the
sale is made. In contrast, in its income tax return the company reports the same installment sale profit proportionally as each installment payment is made over the life of the
installment contract. Is this a situation that may require deferred tax accounting?
Is the following statement one of the three conditions requiring deferred tax accounting: The company accounts differently for the same transactions in its financial
statements and tax returns.
Is the following statement one of the three conditions requiring deferred tax accounting: The different accounting policies lead to a different pattern of profits being
recognized for financial reporting and tax return purposes over time, but in the end theses differences are temporary since the total profit is the same under both accounting
policies.
Is the following statement one of the three conditions requiring deferred tax accounting: Generally, GAAP does not permit the use of the company's installment sale tax
accounting policy in its financial statements.
Is the following statement one of the three conditions requiring deferred tax accounting: The different accounting policies have income tax consequences since the tax return
profit recognition accounting policy pushes the payment of taxes on some of the profit recognized for financial reporting purposes into future periods.
Deferred Tax Liabilities

To see how a deferred tax liability is created, let's return to the example of Pascoe Inc., whose tax and financial reporting books differ because of a difference in the method used
to depreciate a $1000 fixed asset. Recall that the taxes due were $400 in year 1 and $800 in year 2 reflecting the higher depreciation expense permitted by the tax authority in
year 1. Yet in the income statement income before taxes are identical in both years as the depreciation expense is computed on a straight-line basis.
Accounting
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Let's see how the creation of a Deferred Tax Liability is recorded in a company's financial reporting books. As we saw in the Pascoe Inc. depreciation example, the company
owed $400 in taxes in year 1 and $800 in year 2, yet its tax expense in the financial reporting books was $600 for both years.
Press Play to see Pascoe's deferred tax liability and expense journal entries.
Definition
As you can see, a deferred tax liability is an unusual liability. Unlike most liabilities, it is not a present obligation to transfer resources to another entity.
Instead, it is little more than a balancing credit entry to the liability section of the balance sheet to offset a debit entry made to the income statement. This debit entry is made
so that the income statement is not misleading.
Definition:
A deferred tax liability is the future tax consequences attributable to temporary accounting differences between financial and tax accounting policies where the future tax
consequences result in higher future taxes.
Deferred Tax Liability = Future Higher Tax Consequences of a Temporary Accounting Difference
Deferred Tax Assets

As noted above, the deferred tax accrual can also be an asset. To illustrate how this can arise, let's consider the financial reporting and tax books of Cola Company. At the end of
year 1 (its first year of operation), Cola reported gross profits of $8,000. For financial reporting purposes, Cola's only operating expense was a $500 Bad Debt Expense for
expected customer defaults on its $10,000 of accounts receivable. In year 2, Cola's gross profits were $9,000. During year 2, actual losses on customer defaults amounted to
$500, but no accounts receivable were outstanding at year-end so no bad debt expense was needed.
In Cola's tax books, a bad debt deduction would not be recorded in year 1 since the tax authority does not recognize estimated losses and allows companies to deduct only actual
customer defaults that occurred during the year in their tax books. Cola's tax rate is 40%. Cola's income statement in its tax and financial reporting books is as follows:
Accounting
Let's see how the creation of a Deferred Tax Asset is recorded in Cola Company's financial reporting books. Recall that Cola owed $3200 in taxes in year 1 and $3400 in year
2, compared to the tax expense in its financial reporting books of $3000 and 3600 for the same years. This series of events is recorded as follows:
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Definition
Deferred tax assets are the opposite of deferred tax liabilities. Deferred tax assets arise when temporary differences between a company's financial and tax accounting result
in future lower taxes.
Deferred tax assets and their related deferred tax benefits are only recognized in the balance sheet and income statement if management believes it is "more likely than not"
(a better than 50-50 chance) that the future tax benefit will be used to lower the tax payments in subsequent years. This last condition conforms to the conservative concept.
Deferred Tax Asset = More Likely Than Not Future Lower Tax Consequences of a Temporary Accounting Difference
Loss Carryforwards
Deferred tax assets can arise also if there are no temporary differences in reporting methods used for tax and financial reporting books, but the firm reports losses for tax
purposes.
Under the US tax code, companies that report losses on their tax returns can carry forward these losses for tax return purposes for 20 years and apply them as an offset to any
future taxable income. If the current loss is expected to result in lower future tax payments, the tax equivalent of the loss is recorded as a deferred tax asset and a deferred tax
benefit as recognized in the income statement. The amount of the past losses carried forward to offset future taxable income is called a "tax loss carryforward."
The US tax code also provides for "tax loss carrybacks." This provision of the codes permits companies to use their current tax return losses to offset taxable income reported
in prior periods. This may result in a refund of prior period tax payments.
Exercise 12.2
After its first year of operation, Krypton Co. records a loss of $2,500 in both its financial reporting and tax books. Management expects that the company will earn a profit
of $5,000 in year 2. The company's tax rate is 40%. Record the tax expense in the financial statements.
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Exercise 12.3
Buyer Company capitalizes some of its software development costs for financial reporting purposes, but treats 100% of the costs incurred during the year as a deduction for tax
purposes. In the current year, the financial reporting expense for software development is $3,600,000, whereas the tax deduction is $4,200,000. The company's tax rate is
40%.
Does this difference lead to the creation of a:
What amount is recorded in Buyer Company's financial reporting books for Deferred Tax Liability this year? There are no other accounting method differences.
Current and Deferred Tax Expense

The tax expense in a firm's income statement can be divided into two components, the current portion and the deferred portion.
The current portion is the tax due to the tax authority that period.
The deferred portion is the tax accrual required to reflect any temporary accounting differences between financial and tax accounting policies.
For example, recall that for Pascoe, which had a difference in taxable and financial reporting as a result of differences in depreciation methods, the full tax expense in year 1 was
$600. Of this, $400 is taxes due, and is called the current tax expense. The other $200 is the deferred tax expense and reflects the tax effect of the difference in
accelerated and straight-line depreciation used in the tax and financial reporting books.
Example
Spirit Co. has income before depreciation of $5,000 for financial reporting and tax purposes in years 1 and 2. At the beginning of year 1 the firm acquires a depreciable asset
with a 2- year life and no residual value for $800. The asset is depreciated for financial reporting purposes using the straight-line method over a 2-year period. For income
tax return purposes, the company takes the entire $800 purchase price as a tax deduction in the acquisition year. There are no other differences between the company's
financial reporting and tax return accounting. The company pays taxes at a 40% tax rate.
Exercise 12.4
Preston's Inc.'s deferred tax liability at the end of year 1 increases by $2,000 and then decreases by $2,000 in the following year due to the reversal of the temporary
difference between the company's financial reporting and tax return depreciation accounting. What is the effect on the company's year 1 deferred tax expense?
Global Grocer
Now that we have covered deferred tax accounting, let's return to Global Grocer and record its entry for the current year's tax expense. Your financial reporting records indicate
that Global Grocer's earnings before taxes for the year were $641,000. After examining your records, the tax accountant has determined that taxable income was $570,000. The
following table shows where these differences arise:
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Taxes Due
Global Grocer's tax rate is 40%. Use the information from Global Grocer's tax and financial reporting books to estimate the taxes it owes the government for the year.
Taxes Expense
Global Grocer's tax rate is 40%. Use the information from Global Grocer's tax and financial reporting books to estimate the tax expense in its financial reporting books for the
year.
Accounting
Assume Global Grocers' tax rate is 40%. We will now use the information from Global Grocer's tax and financial reporting books to record the journal entry for the year's tax
expense. We will follow the accounting requirement that deferred tax assets and deferred tax liabilities be shown gross (i.e., not "netted") on the balance sheet.
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Recap
In this chapter you have been introduced to accounting for taxes. You have learned that
A firm's taxable income and its earnings before taxes for financial reporting frequently differ. This arises because the objectives of the government, which sets rules for
tax reporting, differ from those of investors who use financial reporting information to allocate resources. As a result, in many counties, firms have separate sets of
books for tax and financial reporting purposes.
Deferred tax accounting is used in a firm's financial reporting books to record an accrual for the tax effect of any temporary differences in earnings that arise from using
different accounting methods in the firm's tax and financial reporting books.
A deferred tax liability is created to record the future tax consequences of temporary accounting differences between financial and tax accounting policies that lead to
higher future taxes.
Deferred tax assets arise when temporary differences between a company's financial and tax accounting result in future lower taxes.
Deferred tax assets can also arise if a firm uses the same accounting policies for tax and financial reporting, but generates tax loss carryforwards.
The tax expense can be divided into two pieces - the current tax expense (which represents the firm's obligation to the government for the current year) and the deferred
tax expense (which represents the adjustment needed to reflect tax effects of temporary differences in accounting policies for tax and financial reporting income during
the year.)
Owners' Equity
In this chapter you will learn about owners' equity and a number of equity transactions. These include:
Paid-in capital
Par value
Issues of preferred stock
Stock repurchases
Dividend distributions
Stock splits
Stock options
Comprehensive income
You will also learn about a key indicator of financial performance for owners. As in previous chapters, you will learn the accounting for these types of transactions by doing the
accounting for Global Grocer.
Management Challenges
As Global Grocer enters the end of its first year of operations, you encounter several new reporting challenges related to owners' equity:
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As you were going through your files, you came across a note from the lawyer involved in setting up Global Grocer that mentioned that Global Grocer's common stock
had a par value of $0.50 per share. You were unsure what this meant or how it should be reported in the financial statements.
Your uncle approaches you about investing in Global Grocer. He proposes investing $20,000 and in return would like you to issue him preferred stock. What is the
difference between preferred and common stock, and how should the new issue be recorded?
After a successful first year, you decide to issue a cash dividend of ten cents per share. How should this be recorded?
After reading an article on stock splits in the business section of the local newspaper, you wonder whether it makes sense for Global Grocer to split its stock, and if so
how such a transaction would be recorded.
One of the early investors in Global Grocer is retiring and would like to sell his shares in the company. You offer to repurchase the stock at a price of $5 per share.
Late in the year you decide to hire Jane McDermott as a senior manager to help you run Global Grocer. In her previous position, Jane received stock options. To attract
her to Global Grocer you will probably have to offer her stock options in Global Grocer. You have heard much about stock options but are not sure what they really entail
and how they should be reported in Global Grocer's books.
You were recently sent the annual report for a public company whose stock you own. As you were flipping through the report you noticed that it presented a
Comprehensive Income Statement in addition to its Income Statement. You wondered how Comprehensive Income differs from regular Net Income, and how they
differ for Global Grocer.
Common Stock
When a company issues common stock, it frequently identifies a nominal value of the stock as its par value. Assigning a par value to a stock is a historical practice that today has
little practical significance. By law each stock certificate has a dollar value printed on its face. This amount is its par or stated value. Par value does not indicate a stock's worth,
but it does have a legal significance. If a shareholder buys stock directly from the issuing company and pays less than the par value, the shareholder could be liable to pay the
difference if called upon by the company's creditors. Today, this could not happen. Most states prohibit the issuance of common stock at less than its par value or the par value
is set at a nominal amount well below the issuance price.
For stock that has a par value, the balance sheet shows the value of the stock at its par value. Of course, the stock is rarely issued at par value. Usually it is issued at a much
higher amount. The difference between the issue amount and the par value is called Additional Paid-in Capital. It also appears on the balance sheet in the owners' equity
section.
The sum of the par value and additional paid-in capital for common stock is called Paid-in Capital.
Global Grocer
Let's look at Global grocer's paid-in capital from common stock. The company had issued 55,000 shares of common stock for $110,000. Given the lawyer's note that par
value was $0.50, we can now break down Global Grocer's paid-in capital into its par value and additional-paid in capital components.
What is the total par value of Global Grocer's common stock?
What is the total additional paid-in capital?
The balance sheet presentation of common stock for Global Grocer will show both the par value and additional paid-in capital components as follows:
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Example
International Food's issued 150,000 new common shares with a par value of $0.10 at a price of $5 per share. Here is the journal entry to record the new share issue.
Preferred Stock
Common stock is the most popular form of equity investment you will encounter. But some companies also issue other classes of stock, notably preferred stock. There are
several important differences between preferred stock and common stock.
Preferred stock is less risky than common stock since it has higher priority in receiving dividend payments and return of capital in the event of a liquidation of the
company.
Preferred stock does not have voting rights.
Preferred stock is typically entitled to a fixed dividend rate, comparable to fixed interest debt. In contrast, common stock is not entitled to any specified dividend
payment.
Types
There are many different types of preferred stock:
Cumulative Preferred Stock: specifies that if the company is unable to pay the preferred dividends in a given year, it cannot pay any common stock dividends until the
preferred dividends in arrears are fully paid.
Convertible Preferred Stock: specifies that the preferred stock can be converted into common stock at a defined exchange rate at the option of the preferred stock owner.
Redeemable Preferred Shares: specify that the issuing company must buy back the preferred shares at a defined price within a defined time period.
Global Grocer
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At the end of your first year of operations, your uncle approaches you about investing in Global Grocer and proposes investing $20,000. Since he is elderly, he would prefer
to receive a fixed return on his investment, and suggests that you issue him preferred rather than common stock. You agree to issue the preferred stock at a 6.5% dividend
rate.
Record the issue of the preferred stock in Global Grocer's books:
Stock Repurchases
Sometimes companies buy back their own common stock. This purchased stock is called treasury stock.
Stock repurchases are very similar to dividends, in that they result in cash being distributed to shareholders.
However, whereas dividends are typically taxed at ordinary income rates, stock repurchases enable some investors to receive cash in a form that leads to a capital gain, which is
typically taxed at capital gains rate that is lower than the rate used to tax ordinary income. This tax difference has led many companies to make distributions to shareholders in
the form of a stock repurchase rather than a dividend.
Accounting
Stock repurchases are reported as a negative owners' equity account in the balance sheet. The stock repurchase value is equal to the price paid to acquire the stock.
For example, consider the following simplified balance sheet for Graphic Inc.
On January 4, the company repurchased $15,000 of its own stock. Let's see how we would record this event. The Treasury Stock account is deducted from shareholder's
equity. As a result, the revised balance sheet is as follows:
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If the company subsequently reissues treasury stock, any gain or loss is treated as an adjustment to additional paid-in capital. A gain or loss on the sale of treasury stock is
never included in the determination of net income.
Global Grocer
At the end of the year, one of the early investors in Global Grocer announced that he was retiring and would like to sell his shares in the company. Global Grocer repurchased
his 2,000 shares at a price of $5 per share. Show the journal entry to record the repurchase.
Dividends
Firms can decide to pay out cash to shareholders in the form of a dividend. Typically, firms avoid paying dividends if they are growing and can reinvest cash generated from
operating the business profitably in new equipment or to support working capital needs.
However, mature firms that produce more cash from operations than they need for funding future growth may decide to pay out excess cash to shareholders in the form of a
dividend.
The stocks of firms that pay dividends are called income stocks, and tend to attract a different class of investor than those that avoid dividends to focus on growth. Investors
attracted to income stocks include:
Retired investors who want a steady stream of income, and

Institutions that do not pay taxes on dividends.
Restrictions
Dividends are declared by a firm's board of directors. In setting a firm's dividend policy, the directors face a number of restrictions.
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State laws prohibit a company from paying dividends out of capital, that is out of funds raised from issuing stock. Dividends can therefore only be paid by firms that have
positive retained earnings. This form of restriction is intended to preclude a firm from liquidating its assets, paying stockholders a liquidating dividend, and leaving creditors
with the company shell.
Contracts with creditors also frequently specify limits to dividends, typically by requiring the firm to maintain minimum debt to equity ratios or by limiting dividends to be
paid only when retained earnings are positive.
Global Grocer
At the end of its first year of operation, Global Grocer earned profits of $397,420. You decide to pay a dividend of ten cents per share. Global Grocer has issued 55,000
shares. Of that total, 2,000 shares are held as Treasury stock, leaving 53,000 shares outstanding. Dividends are only paid on shares outstanding, not on Treasury stock. How
should the dividend be recorded when it is declared? What happens when the dividend is actually paid?
The declaration of a dividend creates a binding commitment to shareholder from the company. The amount of the commitment is $5,300 (or 53,000 shares times ten cents
per share). The commitment is shown as a current liability, usually called Dividends Payable. The other side of the transaction is to reduce Retained Earnings, indicating that
the decision to distribute earnings to shareholders as a dividend, rather than to reinvest earnings. The journal entry for this transaction is as follows:
When the dividend is subsequently paid, the company eliminates its obligation to shareholders and reduces cash, both for the full dividend amount of $5,300. The journal
entry for this transaction is as follows:
Exercise 13.1
Rumble Corp. earned $365,000 for the year. On March 1 it declared a dividend equal to 50% of annual profits. The dividend was paid on March 31. Record the dividend
declaration and payment.
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Stock Splits
Companies sometimes split their stock by increasing the number of shares outstanding. A split changes the number of shares owned by its current shareholders, but does not
change the book values of the firm's assets, liabilities, or its owners' equity.
For example, consider Pilot Inc. that has 10,000 shares outstanding and a stock price of $5, implying that its market capitalization is $50,000 (10,000*$5). A 2-for-1 stock split
would increase the number of shares outstanding by a factor of 2, to 20,000. But since the split has not changed the firm's business fundamentals, its market capitalization
should not change. For this to happen the stock price would have to drop by 50% to $2.50. The firm would now have 20,000 shares outstanding and a stock price of $2.50, and
continue to have a market capitalization of $50,000 (20,000*$2.50).
Some argue that stock splits actually lead to higher market capitalizations for the splitting firms because they signal that management confidence in the firm's future prospects,
or by making it less costly for small investors to own small parcels of shares.
Accounting
Accounting for stock splits is straight-forward. If the firm's stock has a par value, a split changes the par value of the stock but not the aggregate book value of paid-in capital.
To record this change, stock with the old par value need to be removed from the books and stock with the new par value recorded along with an adjustment to the stock's par
value.
For example, recall that Pilot Inc. 2-for-1 stock split increased it shares outstanding from 10,000 to 20,000. If the former par value of these shares was $1.00, the new par
value would decline by 50% to $0.50. To record this transaction the following journal entry would be made:
Notice that the aggregate book value of Common stock at par value would not change, leaving the book value of equity the same. But now, the balance sheet would show a
different par value per share.
Sometimes companies do not change the par value when they split their stock. In these cases, a credit equal to the par value of the stock issued is made to common stock. A
debit for the same amount is made to retained earnings.
Stock splits that result in an issuance of new shares that in total are less than 20 - 25 percent of the outstanding shares are called a stock dividend. In this case, a debit entry
equal to the market value of the shares issued is made to retained earnings. A compound credit entry is made to common stock for the par value of the issued stock along with
an entry to additional paid-in-capital for the difference between the stock's market value and its par value.
Global Grocer
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At the end of its first year of operation, you decide that Global Grocer should make a 2-for-1 stock split, along with an adjustment to the stock's par value, early in its second
year of operation. Given the current $0.50 par value of Global Grocer's stock, what will be the value of its revised par value when the split takes place?
Stock Options
Stock options have become a popular way for companies to reward and motivate their top managers. If a company grants a stock option to a manager, the manager has the
right to buy the stock from the company at a specified price, called the exercise or strike price, within a specified period, called the exercise period.
For example, a company whose stock price is currently worth $20 per share might grant stock options to a manager at an exercise price of $20 with an exercise period of 5
years. If during the next five years the stock appreciates in value to say $40, the manager can benefit from buying the stock from the company at $20 and selling at $40.
However, if the stock declines and never rises above $20 during the exercise period, the manager would choose not exercise the option, since no gain could be realized. The
option is then said to be 'out-of-the-money' meaning that the value of the stock is lower than the option's exercise price.
Benefits and Costs

Stock options granted to top management have a number of benefits:
They motivate the managers to make decisions that increase the value of the company's stock, consistent with the interests of the company's shareholders.
They are a non-cash form of compensation which can be beneficial for cash-constrained young companies.
Since stock options are typically forfeited if the manager leaves the company, stock options provide a way to reduce management turnover.
They attract managers who are entrepreneurial and risk-seeking.
However, stock options also can have costs for the organization:
If the stock price falls significantly after stock options are granted, so that the options are well 'out-of-the-money' they are likely to have limited positive employee
motivation benefit.
Options have been linked to earnings management and fraud as managers at some companies have sought to boost their firms' stock price.
Accounting
Accounting for stock options has proven to be a highly controversial issue. Stock options are certainly a valuable form of compensation for employees that receive them.
However, opinions have varied over how they should be valued and reported.
Prior to 2005, most option grants did not have to be recorded as a compensation expense, either when the option was granted or when it was exercised. However, since then,
standard setters have required companies to estimate the fair value of option grants and to amortize that fair value over the service period. The service period is typically
defined as the period from option grant date to the option vesting date (when the manager officially owns and has the right to exercise the options). The fair value of an
option is determined by a complex equation that is beyond the scope of this tutorial. However, in practice it is easily determined, since most handheld business calculators
are programmed to make the fair value calculation.
For example, consider a company whose stock price is currently worth $20 per share who grants 5,000 stock options to top management at an exercise price of $20 with a
vesting period of 2 years. The fair value of each option is estimated to be $5. The company would then make the following journal entries to record the initial grant,
amortization and exercise of the options.
Grant Date
No entry is needed, since no service has yet been provided by top management.
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End of first and second plan years
A compensation expense needs to be reported since the management has provided a portion of the service. The total cost of the plan is $25,000 ($5*5,000) and the service
period is two years (from date of grant to date of vesting). The annual compensation cost is therefore $12,500, and will be reflected as a debit to compensation expense. The
offsetting credit is made to an owners' equity account called Additional paid-in capital: Stock options, reflecting the value of capital recognized to date from stock option
capital.
At Exercise
Assume that the company's stock price after two years was $30. The managers would then elect to exercise the options. Let's see how this event gets recorded. We have to
record the inflow of cash from the exercise (for 5,000 options at $20, or $100,000). We will also eliminate the $25,000 already credited to Additional paid-in capital: Stock
options and replace it with common stock (reflecting any par value and additional paid-in capital). If the stock has a par value of $1, we will credit Common stock at par value
for $5,000 (5,000 shares at $1) and credit the balance of $120,000 to Additional paid-in capital.
Options expire out-of-the-money
Let's now assume that after two years the stock closes at $15 and the options expire out-of-the-money. How is this event recorded? We will have to transfer the amount of the
Additional Paid-In Capital: Stock Options recognized to date to the general Additional Paid-in Capital account. This requires the following journal entry.
Global Grocer
Late in the year you hired Jane McDermott as a senior manager to help you run Global Grocer. In her previous position, Jane received stock options. To attract her to Global
Grocer you decide to offer her 1,000 options to buy Global Grocer stock at an exercise price of $5 per share. The options expire in five years, vest after three years, and a
friend with finance background estimates that they are worth around $12,000.
What entry will you make at the grant of the options:
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How much compensation expense will you have to record for the options after the first year of Jane's employment?
Comprehensive Income
You were recently sent the annual report for a public company whose stock you own. As you were flipping through the report you noticed that it presented a Comprehensive
Income Statement in addition to its Income Statement. You wondered how Comprehensive Income differs from regular Net Income, and how they differ for Global Grocer.
As we have seen, there are some gains or losses that are not recorded as part of Net Income. For example, in the chapter discussing available-for-sale securities, we saw that such
investments were revalued to their fair value each accounting period. However, these gains were not reported as part of Net Income. Instead, they were shown as a separate
owners' equity account called Unrealized Gain on Available-for-Sale Marketable Securities.
Because the Income Statement does not include all changes in Owners' Equity, standard setters now require firms to prepare a Comprehensive Income Statement to provide
investors with such a reconciliation.
The Comprehensive Income Statement shows changes in shareholders equity arising from all changes other than new investments by or distributions to owners, and in the case
of Global Grocer includes:
Net Income, and

Unrealized gains and losses on available-for-sale securities
Global Grocer
The only owners' equity change for Global Grocer that was not recorded in the Income Statement was an unrealized gain on available-for-sale securities. Given its net income,
Global Grocer's Comprehensive Income Statement would be as follows:
The statement shows that, after including unrealized gains on available-for-sale securities, Global Grocer's Comprehensive Income actually exceeded its Net Income, although
the difference is relatively modest.
Global Grocer's Equity

Below is a revised Balance sheet for Global Grocer, providing the details of Shareholder's Equity after the transactions in this and the earlier chapters have been recorded and
posted.
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Notice that the Owners' Equity includes (a) the equity effect of the preferred stock issue, (b) the common stock at par value as well as Additional paid-in capital, (c) the additional
paid-in capital: Stock option amount resulting from recording a stock option expense, (d) the reduction in Shareholders' Equity from the repurchase of Treasury Stock, (e) the
Comprehensive Income entry for Unrealized gain on available-for-sale securities, and (f) the retained earnings which includes the year's Net Income of $397,420 less the $5,300
dividend.
Equity Ratios: ROE

A key ratio used by investors to evaluate a firm's performance is Return on Equity or ROE. This ratio is simply Net Income divided by Owners' Equity.
The Return on Equity shows how much return the company was able to generate from the investment that shareholders made in the company (both their investment of capital
and the reinvestment of earnings). Shareholders can then evaluate whether the firm's managers have been able to generate a return that compensates them sufficiently for the
risks they bear in owning the company's stock and relative to the performance available from other firms.
Return on Equity = Net Income

Owners' Equity
ROE Drivers
A firm's Return on Equity can be decomposed into three key components or drivers:
Net Income Margin = Net Income

Sales
Asset Turnover = Sales

Total Assets
Financial Leverage = Total Assets

Owners' Equity
This implies that a firm can improve its ROE by (a) increasing net income margins though improved pricing or cost controls, (b) increasing asset turnover, by reducing its
working capital needs or making long-term assets work more productively, or (c) by increasing the firm's financial leverage by taking on additional debt financing.
Return on Equity = Net Income X Sales X Total Assets

Sales Total Assets Owners' Equity
Global Grocer
Since Global Grocer has only been in business for a single year, it probably makes sense to look at its ROE computed using ending Owners' Equity (since beginning equity was
zero).
Ratio Calculation
Let's look at Global Grocer's ROE and the drivers of ROE. Below you will see how each ratio is computed from the summary financial statements for Global Grocer.
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Exercise 13.2
Estimate Ratios
The following financial statements are available for Superior Corp. and Average Corp., two firms that operate hardware stores, for the latest fiscal year:
Estimate the following ratios for Average & Superior. Enter your answers with one decimal place and do not round.
Benchmarks & Interpretation
Which of the following statements is inconsistent with the above ratios?
Recap
In this chapter you covered some advanced accounting topics. You learned:
Owners' equity may include more accounts than just common stock and retained earnings
The common stock account consists of two accounts - common stock at par and additional paid in capital
In addition to issuing common stock, firms can issue Preferred Stock, which has higher priority in bankruptcy and usually has a specified dividend rate.
A form of cash distribution to shareholders is a stock repurchase, which leads to the creation of Treasury Stock, a negative line-item in Owners' Equity.
Dividend distributions result in the payout of cash to shareholders, and reduce reinvested profits.
Stock splits change the number of shares outstanding and the par value of the shares, but they do not affect the book values of total assets, liabilities and equity.
Stock options are designed to help link managers' incentives with those of shareholders. Their estimated value at date of grant is typically recorded as a compensation
expense over the period during which the options vest.
Some gains and losses, such as unrealized gains and losses on available-for-sale securities are deliberately excluded from Net Income, but are included in a
Comprehensive Income Statement and separately reported in Owners' Equity.
Return on Equity (ROE) is a useful measure of the return that a firm generates during the period on owners' equity. It is driven by three factors: operating performance
represented by net profit margins, asset management represented by asset turnover, and the firm's capital structure represented by its financial leverage.
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Congratulations
Now that you have completed the tutorial and prepared Global Grocers' end of first year balance sheet, you should have the ability to prepare, read, interpret and evaluate
reasonably complex financial statements. You will find these to be valuable skills. Congratulations and good luck in the future to you and Global Grocer.

Welcome to the advanced material final exam for the Financial Accounting Online Course. This test will allow you to assess your knowledge of more advanced financial reporting
topics covered in chapters 7-13.
Navigation:
To advance from one question to the next, select one of the answer choices or, if applicable, complete with your own choice and click the “Submit” button. After submitting your
answer, you will not be able to change it, so make sure you are satisfied with your selection before you submit each answer. You may also skip a question by pressing the forward
advance arrow. Please note that you can return to “skipped” questions using the “Jump to unanswered question” selection menu or the navigational arrows at any time. Although
you can skip a question, you must navigate back to it and answer it - all questions must be answered for the exam to be scored.
IMPORTANT: Take this exam only after taking the previous final assessment exams. There are three final assessment exams. Thus, if you did not receive a
passing score on the first or second, it is critical that you review the course material carefully before taking this exam.
Good luck!
Copyright Harvard Business School Publishing. Copying or posting is an infringement of copyright. Permissions@hbsp.harvard.edu or 617-783-7860.
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25/2/2019 Financial Accounting

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Your results will be displayed immediately upon completion of the exam.

Welcome to Financial Accounting

Using the Tutorial

The Accounting Process

Module Overview (continued)

Terms and Concepts

Overview of Financial Reports

Statement of Cash Flows

An income statement is prepared __________.

A statement of cash flows is prepared _________.

Classify the following as Operating, Investing or Financing activities:

Purchase or sale of building

Raising cash from investors

Selling products and services

Money Measurement Concept

Going Concern Concept

Relevance and Reliability

Accrual vs. Cash-Basis

briefly explored three fundamental accounting statements,

The Balance Sheet

Acquired at measurable cost

It involves a probable future sacrifice of economic resources by the entity

The Accounting Equation

Let's Get Global Grocer Started

Current Ratio = Current Assets

Total Debt to Equity Ratio

How a balance sheet is organized.

The Income Statement

Other Line Items

Link to Balance Sheet

Let's Get Going

The First Few Sales

Balance Sheet Effect

Let's Tally Sept. Operations

Expenses of the Period

Net Book Value = Historical Cost - Accumulated Depreciation

Net Book Value = Historical Cost - Accumulated Depreciation

= $40,000 - $300 = $39,700

Preparing for the future

Gross Margin Percentage

Return on Sales Percentage

how an income statement is organized and constructed.

Debits and Credits

August 31 Balance Sheet

Posting Sales to Ledger

Third Party Transactions

Prepare the Balance Sheet

Prepare the Income Statement

The Statement of Cash Flows

Accruals and De-Accruals

Why the indirect method?

Net Income & Op. Cash Flows

(3) Sales-Related De-Accruals

(4) COGS-Related De-Accruals