Appendix: Present Value Tables

Figure 18.1 Present Value of $1

Figure 18.2 Present Value of Annuity Due (annuity in advance—beginning of period payments)

Figure 18.3 Present Value of Ordinary Annuity (annuity in arrears—end of period payments)

Chapter 17: In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 17 “In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?”.

17.1 The Structure of a Statement of Cash Flows

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Describe the purpose of a statement of cash flows.
  2. Define cash and cash equivalents.
  3. Identify the three categories disclosed within a statement of cash flows.
  4. Indicate the type of transactions that are reported as operating activities and provide common examples.
  5. Indicate the type of transactions that are reported as investing activities and provide common examples.
  6. Indicate the type of transactions that are reported as financing activities and provide common examples.

The Importance of a Statement of Cash Flows

Question: Thus far in this textbook, the balance sheet and income statement have been studied in comprehensive detail along with the computation of retained earnings. By this point, a student should be able to access a set of financial statements (on the Internet, for example) and understand much of the reported information. Terms such as “FIFO,” “accumulated depreciation,” “goodwill,” “common stock,” “bad debt expense,” and the like that might have sounded like a foreign language at first should now be understandable.

Examination of one last financial statement is necessary to complete the portrait presented of a reporting entity by financial accounting and the rules of U.S. GAAP. That is the statement of cash flows. This statement was introduced briefly in an earlier chapter but will be covered here in detail. Why is it needed by decision makers? What is the rationale for presenting a statement of cash flows?

 

Answer: Coverage of the statement of cash flows has been postponed until now because its construction is unique. For this one statement, the figures do not come directly from ending T-account balances found in a general ledger. Instead, the accounts and amounts are derived from the other financial statements. Thus, an understanding of those statements is a helpful prerequisite when considering the creation of a statement of cash flows.

The delay in examining the statement of cash flows should not be taken as an indication of its lack of significance. In fact, some decision makers view it as the most important of the financial statements. They are able to see how corporate officials managed to get and then make use of the ultimate asset: cash. The acquisition of other assets, the payment of debts, and the distribution of dividends inevitably leads back to a company’s ability to generate sufficient amounts of cash. Consequently, presentation of a statement of cash flows is required by U.S. GAAP for every period in which an income statement is reported.

To reiterate the importance of this information, Michael Dell, founder of Dell Inc., states in his book Direct from Dell: Strategies That Revolutionized an Industry (written with Catherine Fredman): “We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.”Michael Dell with Catherine Fredman, Direct from Dell: Strategies That Revolutionized an Industry (New York: HarperBusiness, 1999), 47.

The income statement and the statement of cash flows connect the balance sheets from the beginning of the year to the end. During that time, total reported net assets either increase or decrease as does the entity’s cash balance. The individual causes of those changes are explained by means of the income statement and the statement of cash flows.

The purpose of the statement of cash flows is virtually self-evident: It reports the cash receipts (cash inflows) and the cash disbursements (cash outflows) to explain the changes in cash that took place during the year. However, the physical structure of this statement is not self-evident. As illustrated previously, all cash flows are classified within three distinct categories. Coverage here is designed to demonstrate the logic of this classification system and the method by which the reported numbers are derived.

Cash and Cash Equivalents

Question: Because current assets are listed in order of liquidity, most businesses present “cash and cash equivalentsShort-term, highly liquid investments with original maturities of ninety days or fewer that can be readily converted into known amounts of cash.” as the first account on their balance sheets. For example, as of December 31, 2010, Ball Corporation reported holding cash and cash equivalents totaling $152.0 million. This same terminology is used on Ball’s statement of cash flows which explains the drop of $58.6 million in cash and cash equivalents that took place during 2010. What constitutes cash and what are cash equivalents?

 

Answer: Cash consists of coins, currencies, bank deposits (both checking accounts and savings accounts) and some negotiable instruments (money orders, checks, and bank drafts). Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash. They are so near their maturity date that significant changes in value are unlikely. Only securities with original maturities of ninety days or fewer are classified as cash equivalents. Cash equivalents held by most companies include Treasury bills,A Treasury bill is a popular U.S. government security with a maturity date of one-year or less. commercial paper,The term “commercial paper” refers to securities issued by corporations to meet their short-term cash needs. and money market funds.

For the past few years, FASB has been considering the elimination of the cash equivalents category. If a change is made, such assets (other than cash) will likely appear on the balance sheet as temporary investments. As with all such debates, both pros and cons exist for making such an official change. For simplicity purposes, cash will be used in the examples presented throughout this chapter. However, until new authoritative rules are passed, accounting for cash equivalents is the same as that for cash.

Test Yourself

Question:

Which of the following assets is least likely to be considered a cash equivalent?

  1. Treasury bills
  2. Commercial paper
  3. Money market funds
  4. Corporate bonds

Answer:

The correct answer is choice d: Corporate bonds.

Explanation:

Treasury bills, commercial paper, and money market funds are all considered to be cash equivalents as long as they can be converted into cash and had an original maturity of ninety days or fewer. Most corporate bonds have maturity dates much longer than ninety days, often many years.

Cash Flows from Operating Activities

Question: For reporting purposes all cash flows are classified within one of three categories: operating activities, investing activities, and financing activities. What transactions are specifically identified as operating activities?

 

Answer: Operating activitiesA statement of cash flow category used to disclose cash receipts and disbursements arising from the primary activities of the reporting organization. generally involve producing and delivering goods and providing services to customers. These events are those that transpire on virtually a daily basis as a result of the organization’s primary function. For a business like Barnes & Noble, operating activities include the buying and selling of books (and other inventory items) as well as the multitude of other tasks required by that company’s retail function. As shown in Figure 17.1 “Typical Operating Activity Cash Inflows and Outflows”, operating activities are those that are expected to take place regularly in the normal course of business.

Figure 17.1 Typical Operating Activity Cash Inflows and Outflows

The net number for the period (the inflows compared to the outflows) is presented as the cash flows generated from operating activities. This figure is viewed by many decision makers as a good measure of a company’s ability to prosper. Investors obviously prefer to see a positive number, one that increases from year to year. Some analysts believe that this figure is a better reflection of a company’s financial health than reported net income because the ultimate goal of a business is to generate cash.

For example, International Paper Company reported a net loss on its income statement for the year ended December 31, 2008, of $1.282 billion (considerably worse than any of the previous five years). However, its statement of cash flows for the same period reported a net cash inflow from operating activities of $2.669 million (considerably better than any of the previous five years). That is nearly a $4 billion difference. No one could blame a decision maker for being puzzled. Did the company do poorly that year or wonderfully well?

That is the problem with relying on only a few of the numbers in a set of financial statements without a closer and more complete inspection. What caused this company to lose over $1.2 billion dollars? How did the company manage to generate nearly $2.7 billion in cash from its operating activities? In-depth analysis of financial statements is never quick and easy. It requires patience and knowledge and the willingness to dig through all the available information.

Investing Activity Cash Flows

Question: On the statement of cash flows for the year ended August 31, 2011, Walgreen Co. reported that a net of over $1.5 billion in cash was spent in connection with a variety of investing activities. This company’s management obviously made decisions that required the use of considerable sums of money. Details about those expenditures should be of interest to virtually any party analyzing this company. What cash transactions are specifically identified as investing activities?

 

Answer: Investing activitiesA statement of cash flow category used to disclose cash receipts and disbursements arising from an asset transaction other than one relating to the primary activities of the reporting organization. encompass the acquisition and disposition of assets in transactions that are separate from the central activity of the reporting organization. In simple terms, these cash exchanges do not occur as part of daily operations.

  • For a delicatessen, the purchase of bread, mustard, or onions is an operating activity, but the acquisition of a refrigerator or stove is an investing activity.
  • For a pharmacy, the sale of aspirin or a decongestant is an operating activity, but the disposal of a delivery vehicle or cash register is an investing activity.

All of these cash transactions involve assets but, to be classified as an investing activity, they can only be tangentially related to the day-to-day operation of the business. For example, Figure 17.2 “The Three Biggest Investing Activity Cash Flows Identified on Walgreen’s Statement of Cash Flows for the Year Ended August 31, 2011” shows the three biggest investing activity cash flows reported by Walgreen.

Figure 17.2 The Three Biggest Investing Activity Cash Flows Identified on Walgreen’s Statement of Cash Flows for the Year Ended August 31, 2011

Healthy, growing companies normally expect cash flows from investing activities to be negative (a net outflow) as money is invested by management especially in new noncurrent assets. As can be seen in Figure 17.2 “The Three Biggest Investing Activity Cash Flows Identified on Walgreen’s Statement of Cash Flows for the Year Ended August 31, 2011”Walgreen Co. spent over $1.2 billion in cash during this one year to buy property and equipment. The company apparently had sufficient cash available to fund this significant expansion.

Financing Activity Cash Flows

Question: The third category of cash flows lists the amounts received and disbursed by a business through financing activities. For the year ended July 2, 2011, Sara Lee Corporation reported that its cash balance had been reduced by over $1.7 billion as a result of such financing activities. Again, that is a lot of money leaving the company. What transactions are specifically identified in a statement of cash flows as financing activities?

 

Answer: Financing activitiesA statement of cash flow category used to disclose cash receipts and disbursements arising from a liability or stockholders’ equity transaction other than one relating to the primary activities of the organization. are transactions separate from the central, day-to-day activities of an organization that involve either liabilities or shareholders’ equity accounts. Cash inflows from financing activities include issuing capital stock and incurring liabilities such as bonds or notes payable. Outflows are created by the distribution of dividends, the acquisition of treasury stock, the payment of noncurrent liabilities, and other similar cash transactions.

As can be seen in Figure 17.3 “The Three Biggest Financing Activity Cash Flows Identified on Sara Lee’s Statement of Cash Flows for the Year Ended July 2, 2011”Sara Lee’s three biggest changes in cash that resulted from financing activities were the repayments of other debt, purchases of common stock, and borrowing of other debt. Significant information about management’s decisions is readily apparent from an analysis of the cash flows from both investing and financing activities.

Figure 17.3 The Three Biggest Financing Activity Cash Flows Identified on Sara Lee’s Statement of Cash Flows for the Year Ended July 2, 2011

The net result reported for financing activities is frequently positive in some years and negative in others. When a company borrows money or sells capital stock, an overall positive inflow of cash is likely. In years when a large dividend is distributed or debt is settled, the net figure for financing activities is more likely to be negative.

Test Yourself

Question:

The Reardon Company paid salary to its employees totaling $527,000 during the current year. Into which category on a statement of cash flows will these payments be placed?

  1. Operating activities
  2. Investing activities
  3. Financing activities
  4. Capital activities

Answer:

The correct answer is choice a: Operating activities.

Explanation:

The payment of salary is a regular operating activity. The expenditure takes place as a direct result of the day-to-day operations of the business.

Test Yourself

Question:

The McGuire Company, located in Wilcox, Texas, issued 10,000 shares of its $3 par value common stock during this year for $9 in cash per share. Into which category on a statement of cash flows will this $90,000 capital contribution be placed?

  1. Operating activities
  2. Investing activities
  3. Financing activities
  4. Capital activities

Answer:

The correct answer is choice c: Financing activities.

Explanation:

This issuance of common (and preferred) stock is identified as a financing activity. It represents a change in a shareholders’ equity account. However, the cash inflow is not directly related to the daily operations of the business.

Test Yourself

Question:

The Staunton Corporation owns and operates several restaurants in eastern Iowa. Looking to expand operations, Staunton bought a piece of land recently for $500,000. The business paid $100,000 and a noncurrent note payable was signed for the remaining $400,000. How is this transaction reported on a statement of cash flows?

  1. Investing activity as an outflow of $100,000
  2. Investing activity as an outflow of $500,000
  3. Financing activity as an outflow of $100,000
  4. Financing activity as an outflow of $500,000

Answer:

The correct answer is choice a: Investing activity as an outflow of $100,000.

Explanation:

The purpose of the transaction is to acquire land. Land is an asset and this event did not take place as a normal part of Staunton’s daily operations. Thus, the transaction is an investing activity. Because $100,000 in cash was spent for this acquisition, the transaction is reported as an outflow of that amount. The $500,000 cost of the land and the $400,000 note payable will be recorded on the corporation’s balance sheet.

Disclosure of Noncash Transactions

Question: Significant investing and financing transactions can occur without any cash component. Land, for example, might be obtained by issuing common stock. Buildings are often bought through the signing of a long-term note payable with all cash payments deferred into the future. Is that information omitted entirely from the statement of cash flows? If no cash is received or expended, should a transaction be reported on a statement of cash flows?

 

Answer: All investing and financing transactions need to be reported in some manner because of the informational value. They represent choices made by the organization’s management. Even if no cash is involved, such events must still be disclosed in a separate schedule (often attached to the statement of cash flows) or explained in the notes to the financial statements. This information is valuable to the interested parties who want a complete picture of the investing and financing decisions that were made during the period.

For example, on the statement for Duke Energy Corporation for the year ended December 31, 2010, a significant noncash transaction was identified as “accrued capital expenditures” of $361 million. Although cash was not involved, inclusion of this information was still deemed to be important.

Stock dividends and stock splits, though, are omitted entirely in creating a statement of cash flows. As discussed previously, they are viewed as techniques to reduce the price of a corporation’s stock and are not decisions that impact the allocation of financial resources.

Key Takeaway

A statement of cash flows is required by U.S. GAAP whenever an income statement is presented. It explains all changes occurring in cash and cash equivalents during the reporting period. The various cash inflows and outflows are classified into one of three categories. Operating activities result from the primary or central function of the business. Investing activities are not part of normal operations and affect an asset (such as the cash acquisition of a truck or the sale of a patent). Financing activities are not part of normal operations and involve a liability or a stockholders’ equity account (borrowing money on a note, for example, or the reacquisition of treasury stock). Significant investing and financing activities that do not impact cash must still be disclosed because they reflect decisions made by management.

17.2 Cash Flows from Operating Activities: The Direct Method

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Identify the two methods available for reporting cash flows from operating activities.
  2. Indicate the method of reporting cash flows from operating activities that is preferred by FASB as well as the one that is most commonly used in practice.
  3. List the steps to be followed in determining cash flows from operating activities.
  4. List the income statement accounts that are removed entirely in computing cash flows from operating activities and explain this procedure when the direct method is applied.
  5. Identify common “connector accounts” that are used to convert accrual accounting figures to the change taking place in the cash balance as a result of these transactions.
  6. Compute the cash inflows and outflows resulting from common revenues and expenses such as sales, cost of goods sold, rent expense, salary expense, and the like.

The Handling of Noncash and Nonoperating Transactions by the Direct Method

Question: The net cash inflow or outflow generated by operating activities is especially significant information to any person looking at an organization’s financial health and future prospects. According to U.S. GAAP, that information can be presented within the statement of cash flows by either of two approaches: the direct methodA mechanical method of reporting the amount of cash flows that a company generates from its operating activities; it is preferred by FASB because the information is easier to understand but it is only rarely encountered in practice. or the indirect methodA mechanical method of reporting the amount of cash flows that a company generates from its operating activities; it is allowed by FASB (although the direct method is viewed as superior) but is used by a vast majority of businesses in the United States..

The numerical amount of the change in cash resulting from a company’s daily operations is not impacted by this reporting choice. The increase or decrease in cash is a fact that will not vary because of the manner of presentation. Both methods arrive at the same total. The informational value to decision makers, though, is potentially affected by the approach selected.

FASB has indicated a preference for the direct method. In contrast, reporting companies (by an extremely wide margin) continue to use the more traditional indirect method. Thus, both will be demonstrated here. The direct method is more logical and will be discussed first. How is information presented when the direct method is selected to disclose a company’s cash flows from operating activities?

 

Answer: The direct method starts with the entire income statement for the period. Then, each of the separately reported figures is converted into the amount of cash received or spent in carrying on this operating activity. “Sales,” for example, is turned into “cash collected from customers.” “Salary expense” and “rent expense” are recomputed as “cash paid to employees” and “cash paid to rent facilities.”

For illustration purposes, assume that Liberto Company prepared its income statement for the year ended December 31, Year One, as shown in Figure 17.4 “Liberto Company Income Statement Year Ended December 31, Year One”. This statement has been kept rather simple so that the conversion to cash flows from operating activities is not unnecessarily complex. For example, income tax expense has been omitted.

Figure 17.4 Liberto Company Income Statement Year Ended December 31, Year One

The $100,000 net income figure reported here by Liberto is based on the application of U.S. GAAP. However, the amount of cash generated by the company’s operating activities might be considerably more or much less than that income figure. It is a different piece of information.

To transform a company’s income statement into its cash flows from operating activities, several distinct steps must be taken. These steps are basically the same regardless of whether the direct method or the indirect method is applied.

The first step is the complete elimination of any income statement account that does not involve cash. Although such balances are important in arriving at net income, they are not relevant to the cash generated and spent in connection with daily operations. By far the most obvious example is depreciation. This expense appears on virtually all income statements but has no direct impact on a company’s cash. In determining cash flows from operating activities, it is omitted because depreciation is neither a source nor use of cash. It is an allocation of a historical cost to expense over an asset’s useful life. To begin the calculation of the cash flows resulting from Liberto’s operating activities, the $80,000 depreciation expense must be removed.

The second step is the removal of any gains and losses that resulted from investing or financing activities. Although cash was likely involved in these transactions, this inflow or outflow is reported elsewhere in the statement of cash flows and not within the company’s operating activities. For example, Liberto’s $40,000 gain on the sale of equipment is germane to the reporting of investing activities, not operating activities. The cash received in this disposal is included on the statement of cash flows but as an investing activity.

Neither (a) noncash items such as depreciation nor (b) nonoperating gains and losses are included when an income statement is converted to the cash flows from operating activities.

Converting Accrual Accounts to Cash Flows—The Direct Method

Question: After all noncash and nonoperating balances are deleted, Liberto is left with four income statement accounts:

  1. Sales to customers—$480,000
  2. Cost of goods sold—$250,000
  3. Salary expense—$60,000
  4. Rent expense—$30,000

These balances all relate to operating activities. However, the numbers reflect the application of U.S. GAAP and accrual accounting rather than the amount of cash exchanged. The cash effects must be determined individually for these accounts. How are income statement figures such as sales or rent expense converted to the amount of cash received or expended?

 

Answer: The third step in the process of determining cash flows from operating activities is the individual conversion to cash of all remaining income statement accounts. For these balances, a difference usually exists between the time of recognition as specified by accrual accounting and the exchange of cash. A sale is made on Monday (revenue is recognized), but the money is not collected until Friday. An employee performs work on Monday (expense is recognized) but payment is not made until Friday.

These timing differences occur because accrual accounting is required by U.S. GAAP. Thus, many revenues and expenses are not recorded at the same time as the related cash transactions. In the interim, recognition of an asset or liability balance is necessary. Between the sale on Monday and the collection on Friday, the business reports an account receivable. This asset goes up when the sale is made and down when the cash is collected. Between the employee’s work on Monday and the payment on Friday, the business reports a salary payable. This liability goes up when the money is earned and down when the cash payment is made. In this textbook, these interim accounts (such as accounts receivable and salary payable) will be referred to as “connector accounts” because they connect the recording mandated by accrual accounting with the cash transaction.

Each income statement account (other than the noncash and nonoperating numbers that have already been eliminated) has at least one asset or liability that is recorded between the time of accounting recognition and the exchange of cash. The changes in these connector accounts can be used to convert the individual income statement figures to their cash equivalents. Basically, the increase or decrease is removed to revert the reported number back to the amount of cash involved. As can be seen in Figure 17.5 “Common Connector Accounts for Liberto’s Four Income Statement Balances”, connector accounts are mostly receivables, payables, and prepaid expenses.

Figure 17.5 Common Connector Accounts for Liberto’s Four Income Statement BalancesFor convenience, the allowance for doubtful accounts will not be included with accounts receivable. The possibility of bad debts makes the conversion to cash more complicated and is covered in upper-level accounting textbooks.

If a connector account is an asset and the balance goes up, the business has less cash (the receivable was not collected, for example). If a connector account is an asset and goes down, the business has more cash (such as when receivables from previous years are collected in the current period). Therefore, for a connector account that is an asset, an inverse relationship exists between the change in the balance during the year and the reporting entity’s cash balance.

  • Increase in connector account that is an asset → Lower cash balance
  • Decrease in connector account that is an asset → Higher cash balance

If a connector account is a liability and the balance goes up, the business has saved its cash and holds more (an expense has been incurred but not yet paid, for example). If a connector account is a liability and this balance falls, the business must have used its cash to reduce the debt and has less remaining. Consequently, a direct relationship exists between the change in a connector account that is a liability and the cash balance.

  • Increase in connector account that is a liability → Higher cash balance
  • Decrease in connector account that is a liability → Lower cash balance

Applying the Direct Method to Determine Cash Revenues and Expenses

Question: Liberto has one revenue and three expenses left on its income statement after removal of noncash and nonoperating items. To arrive at the net cash flows from operating activities, the cash inflow or outflow relating to each must be determined. Assume that the following changes took place during this year in the related balance sheet connector accounts:

  • Accounts receivable: up $19,000
  • Inventory: down $12,000
  • Prepaid rent: up $4,000
  • Accounts payable: up $9,000
  • Salary payable: down $5,000

In applying the direct method to determine operating activity cash flows, how are the individual figures to be disclosed computed?

 

Answer:

  • Sales to customers were reported on the income statement as $480,000. During that same period, accounts receivable increased by $19,000. Thus, less money was collected than the amount of the company’s credit sales. That is the cause for a rise in receivables. To reflect the collection of less cash, a reduction is needed. Consequently, the cash received from customers was only $461,000 ($480,000 less $19,000).
  • Salary expense was reported as $60,000. During that time period, salary payable went down by $5,000. More cash must have been paid to cause this drop in the liability. The amount actually paid to employees was $65,000 ($60,000 plus $5,000).
  • Rent expense was reported as $30,000. Prepaid rent increased by $4,000 from the first of the year to the end. This connector account is an asset. Because this asset increased, Liberto must have paid an extra amount for rent. Cash paid for rent was $34,000 ($30,000 plus $4,000).
  • Cost of goods sold has been left to last because it requires an extra step. The company first determines the quantity of inventory bought during this period. Only then can the cash payment made for those acquisitions be determined.

    • Cost of goods sold is reported as $250,000. However, the balance held in inventory fell by $12,000. Thus, the company bought $12,000 less inventory than it sold. Fewer purchases cause a drop in inventory. The amount of inventory acquired during the period was only $238,000 ($250,000 less $12,000).
    • Next, the cash paid for those purchases is calculated. As indicated, accounts payable went up $9,000. Liabilities increase because less money is paid. Although $238,000 of merchandise was acquired, only $229,000 in cash payments were made ($238,000 less $9,000).

After each of these four income statement accounts is converted to the amount of cash received or paid this period, the operating activity section of the statement of cash flows can be created by the direct method as shown in Figure 17.6 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method”.

Figure 17.6 Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method

Liberto’s income statement reported net income of $100,000. However, the cash generated by operating activities during this same period was $133,000. The conversion from accrual accounting to operating cash inflows and outflows required three steps.

  1. All noncash revenues and expenses (depreciation, in this example) were removed. These accounts do not represent cash transactions.
  2. All nonoperating gains and losses (the gain on sale of equipment, in this example) were removed. These accounts reflect investing and financing activities and the resulting cash flows are reported in those sections of the statement of cash flows rather than within the operating activities.
  3. All remaining income statement accounts are adjusted to the amount of cash physically exchanged this period by applying the change in each related connector account. By this process, accrual accounting figures are converted to cash balances.

Test Yourself

Question:

The Giotto Company reported sales in its latest year of $800,000. Giotto held $170,000 in accounts receivable at the beginning of the period but only $144,000 at the end. Assume that all of these receivables are viewed as collectible so that no allowance is needed. What amount of cash did the company collect this period from its customers?

  1. $774,000
  2. $776,000
  3. $824,000
  4. $826,000

Answer:

The correct answer is choice d: $826,000.

Explanation:

During this year, the accounts receivable balance dropped by $26,000 ($170,000 to $144,000). Thus, more cash was collected than the amount of sales. Receivables decrease because cash is received. These additional receipts indicate that a total of $826,000 was collected from the Giotto’s customers ($800,000 plus $26,000).

Test Yourself

Question:

The Lessain Company reported salary expense of $345,000 on its income statement for the year ended December 31, Year One. At the beginning of that year, salary payable was shown as $31,000 but rose to $40,000 by December 31. In reporting the Lessain’s cash flows generated from operating activities, what amount should be shown as the cash paid to employees?

  1. $336,000
  2. $345,000
  3. $354,000
  4. $376,000

Answer:

The correct answer is choice a: $336,000.

Explanation:

Lessain’s salary payable went up by $9,000. Accrued liabilities rise because fewer payments are made than the expenses incurred. Although employees earned $345,000 during this year, only $336,000 was paid to them as salary ($345,000 less $9,000). It is this reduction in the cash payment that caused the salary payable account to increase by $9,000 during Year One.

Test Yourself

Question:

The TJ Corporation reported cost of goods sold for Year One of $564,000. During that same period, this company’s inventory balance rose by $22,000 while its accounts payable fell by $7,000. In creating a statement of cash flows using the direct method, what amount should be reported by the TJ Corporation as the cash spent to acquire inventory?

  1. $535,000
  2. $549,000
  3. $579,000
  4. $593,000

Answer:

The correct answer is choice d: $593,000.

Explanation:

Although cost of goods sold was reported as $564,000, the inventory on hand increased $22,000. More inventory was bought that year than sold. TJ acquired $586,000 in inventory during Year One ($564,000 sold plus the $22,000 increase). At the same time, accounts payable dropped. This decrease indicates that more in cash was paid than the amount bought. Spending an extra $7,000 caused the reduction. Thus, cash paid out this year to acquire inventory was $593,000 ($586,000 plus $7,000).

Test Yourself

Question:

Sales reported by a local shoe store are $470,000. Accounts receivable decreased by $27,000 this year while unearned revenues rose by $14,000. If the direct method is used to report cash flows from operating activities, how much should be shown as the store’s cash collected from its customers?

  1. $429,000
  2. $467,000
  3. $483,000
  4. $511,000

Answer:

The correct answer is choice d: $511,000.

Explanation:

A new connector account (unearned revenues) is included here. This balance represents cash received where revenue has not yet been earned. This increase indicates that $14,000 more in cash was collected from customers than the amount reported as revenue. Also, accounts receivable fell by $27,000. Receivables are reduced through collection. The shoe store must have received that much more cash than it earned. Cash received during this period is $511,000 ($470,000 plus $14,000 and $27,000).

Key Takeaway

An entity’s cash flows from operating activities can be derived and reported by either the direct method or the indirect method. FASB has expressed preference for the direct method but the indirect method has been adopted by virtually all businesses in the United States. The process always begins with the income for the period (the entire income statement is used when the direct method is applied). First noncash items (such as depreciation) and then nonoperating gains and losses are eliminated entirely because they are not related to operating activity cash flows. In the direct method, the remaining revenue and expense accounts are individually converted into cash figures. For each, the change in one or more related balance sheet connector accounts is used to adjust these accrual accounting numbers to their corresponding cash balances. Thus, income statement balances are returned to their underlying cash inflows and outflows for reporting purposes.

17.3 Cash Flows from Operating Activities: The Indirect Method

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Explain the difference in the start of the operating activities section of the statement of cash flows when the indirect method is used rather than the direct method.
  2. Demonstrate the removal of both noncash items and nonoperating gains and losses in the application of the indirect method.
  3. Determine the effect caused by the change in the various connector accounts when the indirect method is used to present cash flows from operating activities.
  4. Identify the reporting classification for interest revenues, dividend revenues, and interest expense in creating a statement of cash flows and explain the controversy that resulted from this handling.

The Steps Followed in Applying the Indirect Method

Question: As mentioned, most organizations do not choose to present their operating activity cash flows using the direct method despite the preference of FASB. Instead, this information is almost universally shown within a statement of cash flows by means of the indirect method. How does the indirect method of reporting operating activity cash flows differ from the direct method?

 

Answer: The indirect method actually follows the same set of procedures as the direct method except that it begins with net income rather than the business’s entire income statement. After that, the same three steps demonstrated previously to determine the net cash flows from operating activities are followed although the mechanical application here is different.

  1. Noncash items are removed.
  2. Nonoperational gains and losses are removed.
  3. Adjustments are made, based on the monetary change occurring during the period in the various balance sheet connector accounts, to switch all remaining revenues and expenses from accrual accounting to cash accounting.

Removing Noncash and Nonoperating Items—The Indirect Method

Question: In the income statement presented in Figure 17.4 “Liberto Company Income Statement Year Ended December 31, Year One” for the Liberto Company, net income was reported as $100,000. This figure included depreciation expense (a noncash item) of $80,000 and a gain on the sale of equipment (an investing activity rather than an operating activity) of $40,000. In applying the indirect method, how are noncash items and nonoperating gains and losses removed from net income?

 

Answer: First, all noncash items within net income are eliminated. Depreciation is the example included here. As an expense, it is a negative component found within net income. To remove a negative, it is offset by a positive. Thus, adding back $80,000 serves to remove the impact of depreciation from the reporting company’s net income.

Second, all nonoperating items within net income are eliminated. Liberto’s gain on sale of equipment is reported within reported income. As a gain, it is a positive figure; it helped increase profits this period. To eliminate this gain, $40,000 must be subtracted from net income. The cash flows resulting from this transaction came from an investing activity and not an operating activity.

In applying the indirect method, as shown in Figure 17.7 “Operating Activity Cash Flows, Indirect Method—Elimination of Noncash and Nonoperating Balances”, a negative is removed by addition; a positive is removed by subtraction.

Figure 17.7 Operating Activity Cash Flows, Indirect Method—Elimination of Noncash and Nonoperating Balances

  • In the direct method, these two income statement amounts were simply omitted in arriving at the individual cash flows from operating activities.
  • In the indirect method, they are both physically removed from income by reversing their effect.

The impact is the same in the indirect method as in the direct method; the balances are removed.

Converting Accrual Accounting Figures to Cash Balances—The Indirect Method

Question: After all noncash and nonoperating items are removed from net income, only the changes in the balance sheet connector accounts must be utilized to complete the conversion to cash. For Liberto, those balances were shown previously.

  • Accounts receivable: up $19,000
  • Inventory: down $12,000
  • Prepaid rent: up $4,000
  • Accounts payable: up $9,000
  • Salary payable: down $5,000

Each of these increases and decreases was used in the direct method to turn accrual accounting figures into cash balances. That same process is followed in the indirect method. In determining cash flows from operating activities, how are changes in an entity’s connector accounts reflected in the application of the indirect method?

 

Answer: Although the procedures appear to be different, the same logic is applied in the indirect method as in the direct method. The change in each of the previous connector accounts discloses the difference in the accrual accounting amounts recognized in the income statement and the actual changes in cash. Here, though, the effect is measured on net income as a whole rather than on the individual revenue and expense accounts.

Accounts receivable increased by $19,000. This rise in the receivable balance shows that less money was collected than the sales made by Liberto during the period. Receivables go up because customers are slow to pay. This change results in a lower cash balance. Thus, the $19,000 is subtracted in arriving at the cash flow amount generated by operating activities. The cash received was actually less than the figure reported for sales that appears within the company’s net income. Subtract $19,000.

Inventory decreased by $12,000. A drop in the amount of inventory on hand indicates that less merchandise was purchased during the period. Buying less requires a smaller amount of cash to be paid. That leaves the cash balance higher. The $12,000 is added in arriving at the operating activity change in cash. Add $12,000.

Prepaid rent increased by $4,000. An increase in any prepaid expense shows that more of the asset was acquired during the year than was consumed. This additional purchase requires the use of cash; thus, the resulting cash balance is lower. The increase in prepaid rent necessitates a $4,000 subtraction in the operating activity cash flow computation. Subtract $4,000.

Accounts payable increased by $9,000. Any jump in a liability means that Liberto paid less cash during the period than the debts that were incurred. Postponing liability payments is a common method for saving cash to keep the reported balance high. In determining cash flows from operating activities, the $9,000 liability increase is added. Add $9,000.

Salary payable decreased by $5,000. Liability balances fall when additional payments are made. Such cash transactions are reflected in applying the indirect method by a $5,000 subtraction from net income. Subtract $5,000.

Therefore, if Liberto Company uses the indirect method to report its cash flows from operating activities, the information will be presented to decision makers as shown in Figure 17.8 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method”.

Figure 17.8 Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method

As with the direct method (Figure 17.6 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method”), the total here reflects a net cash inflow of $133,000 from the operating activities of this company. In both cases, the starting spot was net income (either as the entire income statement or as the single number). Then, all noncash items were removed as well as nonoperating gains and losses. Finally, the effect of changes in the various connector accounts that bridge the time period between accrual accounting recognition and the cash exchange are included so that only the cash flows from operating activities remain.

In reporting operating activity cash flows by means of the indirect method (Figure 17.8 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method”), the following pattern can be seen.

  • A change in a connector account that is an asset is reflected on the statement in the opposite fashion. As shown previously, increases in both accounts receivable and prepaid rent are subtracted while a decrease in inventory is added.
  • A change in a connector account that is a liability is included on the statement in an identical change. An increase in accounts payable is added whereas a decrease in salary payable is subtracted.

A quick visual comparison of the direct method (Figure 17.6 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Direct Method”) and the indirect method (Figure 17.8 “Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported by Indirect Method”) makes the two appear almost completely unrelated. However, when analyzed more closely, the same series of steps can be seen in each. They both begin with the income for the period. Noncash items and nonoperating gains and losses are removed. Changes in the connector accounts for the period are factored in so that only the cash from operating activities remains.

Test Yourself

Question:

The Hemingway Company reported net income last year of $354,000. Within that figure, depreciation expense of $37,000 was included. In addition, accounts receivable increased by $11,000 during the period. What amount of cash did this company generate from its operating activities?

  1. $306,000
  2. $328,000
  3. $380,000
  4. $402,000

Answer:

The correct answer is choice c: $380,000.

Explanation:

Depreciation is a noncash expense that appears within net income as a negative. To remove it, the $37,000 figure is added. Addition counterbalances the original negative effect. The increase in accounts receivable means that customers were slow to pay this year. Credit sales were greater than the amount of cash received. The $11,000 is subtracted from net income to arrive at the lower cash figure. Thus, cash inflow from operating activities is $380,000 ($354,000 + $37,000 − $11,000).

Test Yourself

Question:

The Faulkner Corporation reported net income in Year One of $437,000. Accounts receivable at the start of the period totaled $26,000 but grew to $41,000 by the end of Year One. Beginning insurance payable was $7,000 but fell to an ending balance of $4,000. What amount of cash did Faulkner collect as a result of its operating activities?

  1. $419,000
  2. $425,000
  3. $449,000
  4. $455,000

Answer:

The correct answer is choice a: $419,000.

Explanation:

Accounts receivable went from $26,000 to $41,000. The $15,000 increase indicates that credit sales were greater than cash collected. The $15,000 is subtracted from net income. Insurance payable fell by $3,000 ($7,000 to $4,000); thus, the amount paid was greater than the expense recognized. Cash was spent to reduce the liability. The $3,000 is also subtracted in arriving at the cash change. The cash inflow from operating activities is $419,000 ($437,000 net income − $15,000 and $3,000).

The Reporting of Dividends and Interest on the Statement of Cash Flows

Question: When listing cash flows from operating activities for the year ended December 31, 2010, EMC Corporation (a technology company) included an inflow of nearly $103 million labeled as “dividends and interest received” as well as an outflow of over $76 million shown as “interest paid.”

Unless a company is a bank or financing institution, dividend and interest revenues do not appear to relate to its central operating function. For most businesses, these cash inflows are fundamentally different from the normal sale of goods and services. Monetary amounts collected as dividends and interest resemble investing activity cash inflows because they are often generated from noncurrent assets. Similarly, interest expense payments are normally associated with noncurrent liabilities rather than resulting from daily operations. Interest expenditures could certainly be viewed as a financing activity cash outflow.

Dividend distributions are not in question here. They are labeled as financing activity cash outflows because they are made directly to stockholders. The issue is the classification of dividend and interest revenue collections and interest expense payments. Why is cash received as dividends and interest and cash paid as interest expense reported within operating activities on a statement of cash flows rather than as investing activities and financing activities?

 

Answer: Authoritative pronouncements that create U.S. GAAP are the subject of years of intense study, discussion, and debate. In this process, controversies often arise. When FASB issued its official standard on cash flows in 1987, three of the seven board members voted against passage. Their opposition, at least in part, came from the handling of interest and dividends. On page ten of Statement 95, Statement of Cash Flows, these three argue “that interest and dividends received are returns on investments in debt and equity securities that should be classified as cash inflows from investing activities. They believe that interest paid is a cost of obtaining financial resources that should be classified as a cash outflow for financing activities.”

The other board members were not convinced. Thus, inclusion of dividends collected, interest collected, and interest paid within an entity’s operating activity cash flows became a requirement of U.S. GAAP. Such disagreements arise frequently in the creation of official accounting rules.

The majority of the board apparently felt that—because these transactions occur on a regular ongoing basis—a better portrait of the organization’s cash flows is provided by inclusion within operating activities. At every juncture of financial accounting, multiple possibilities for reporting exist. Rarely is complete consensus ever achieved as to the most appropriate method of presenting financial information.

Talking With an Independent Auditor about International Financial Reporting Standards

Following is the conclusion of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: Any company that follows U.S. GAAP and issues an income statement must also present a statement of cash flows. Cash flows are classified as resulting from operating activities, investing activities, or financing activities. Are IFRS rules the same for the statement of cash flows as those found in U.S. GAAP?

Rob Vallejo: Differences do exist between the two frameworks for the presentation of the statement of cash flows, but they are relatively minor. Probably the most obvious issue involves the reporting of interest and dividends that are received and paid. Under IFRS, interest and dividend collections may be classified as either operating or investing cash flows whereas, in U.S. GAAP, they are both required to be shown within operating activities. A similar difference exists for interest and dividend payments. These cash outflows can be classified as either operating or financing activities according to IFRS. For U.S. GAAP, interest payments are viewed as operating activities whereas dividend payments are considered financing activities.

Key Takeaway

Most reporting entities use the indirect method to report net cash flows from operating activities. This presentation begins with net income and then eliminates any noncash items (such as depreciation expense) as well as nonoperating gains and losses. Their impact on net income is reversed to create this removal. In addition, changes in each balance sheet connector account (such as accounts receivables, inventory, accounts payable, and salary payable) must also be utilized in converting from accrual accounting to cash. Changes in asset connectors are reversed in arriving at cash flows from operating activities whereas changes in liability connectors have the same impact (increases are added and decreases are subtracted). Cash transactions that result from interest revenue, dividend revenue, and interest expense are all reported within operating activities because they happen on a regular ongoing basis. However, some argue that interest and dividend collections are really derived from investing activities and interest payments relate to financing activities.

17.4 Cash Flows from Investing and Financing Activities

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Analyze the changes in assets that are not operating assets to determine cash inflows and outflows from investing activities.
  2. Analyze the changes in liabilities (that are not operating liabilities) and stockholders’ equity accounts to determine cash inflows and outflows from financing activities.
  3. Recreate journal entries to determine the individual effects on ledger accounts where several cash transactions have occurred.

Determining Cash Flows from Investing Activities

Question: As shown in Figure 17.9 “The Walt Disney Company Investing Activity Cash Flows for Year Ended October 2, 2010”The Walt Disney Company reported a net cash outflow of over $4.5 billion as a result of investing activities undertaken during the year ended October 2, 2010.

Figure 17.9 The Walt Disney Company Investing Activity Cash Flows for Year Ended October 2, 2010

This section of Disney’s statement of cash flows shows that a number of transactions involving assets (other than operating assets such as inventory and accounts receivable) created this $4.5 billion reduction in cash. Information about management decisions is readily available. For example, a potential investor can see that officials chose to spend over $2.1 billion in cash during this year in connection with Disney’s parks, resorts and other property. Interestingly, this expenditure level is approximately 20 percent higher than the monetary amount invested in those assets the previous year. With a strong knowledge of financial accounting, a portrait of a business and its activities begins to become clear.

After the various cash amounts are determined, conveyance of this information does not appear particularly complicated. How does a company arrive at the investing activity figures that are disclosed within the statement of cash flows?

 

Answer: Here, the accountant is not interested in assets such as inventory, accounts receivable, and prepaid rent because they are included within operating activities. Instead, each of the other asset accounts (land, buildings, equipment, patents, trademarks, and the like) is investigated to determine the individual transactions that took place during the year. The amount of every cash change is identified and reported. A sale of land can create a cash inflow whereas the acquisition of a building may well require the payment of some amount of cash.

The difficulty in this process frequently comes from having to sort through multiple purchases and sales to compute the exact amount of cash involved in each transaction. At times, determining the individual cash effects can resemble the work needed to solve a puzzle with many connecting pieces. Often, the journal entries that were made originally must be replicated. Even then, the cash portion of these transactions may have to be determined by mathematical logic. To illustrate, assume that the Hastings Company reports the account balances that appear in Figure 17.10 “Account Balances to Illustrate Cash Flows from Investing Activities”.

Figure 17.10 Account Balances to Illustrate Cash Flows from Investing Activities

In looking through the financial records maintained by this business, assume the accountant finds two additional pieces of information about the accounts in Figure 17.10 “Account Balances to Illustrate Cash Flows from Investing Activities”:

  • Equipment costing $600,000 was sold this year for cash.
  • Other equipment was acquired, also for cash.

Sale of equipment. This transaction is analyzed first because the cost of the equipment is already provided. However, the accumulated depreciation relating to the disposed asset is not known. The accountant must study the available data to determine that missing number because that balance is also removed when the asset is sold.

Accumulated depreciation at the start of the year was $300,000 but depreciation expense of $230,000 was then reported as shown in Figure 17.10 “Account Balances to Illustrate Cash Flows from Investing Activities”. This expense was apparently recognized through the year-end adjustment recreated in Figure 17.11 “Assumed Adjusting Entry for Depreciation”.

Figure 17.11 Assumed Adjusting Entry for Depreciation

The depreciation entry increases the accumulated depreciation account to $530,000 ($300,000 plus $230,000). However, the end-of-year balance is not $530,000 but only $450,000. What caused the $80,000 drop in this contra asset account?

Accumulated depreciation represents the cost of a long-lived asset that has already been expensed. Virtually the only situation in which accumulated depreciation is reduced is the disposal of the related asset. Here, the accountant knows equipment was sold. Although the amount of accumulated depreciation relating to that asset is unknown, the assumption can be made that the sale caused this reduction of $80,000. No other possible decrease in accumulated depreciation is mentioned.

Thus, the accountant believes equipment costing $600,000 but with accumulated depreciation of $80,000 (and, hence, a net book value of $520,000) was sold. The amount received must have created the $74,000 gain that is shown in the reported balances in Figure 17.10 “Account Balances to Illustrate Cash Flows from Investing Activities”.

A hypothetical journal entry can be constructed in Figure 17.12 “Assumed Journal Entry for Sale of Equipment” from this information.

Figure 17.12 Assumed Journal Entry for Sale of Equipment

This journal entry only balances if the cash received is $594,000. Equipment with a book value of $520,000 was sold during the year at a reported gain of $74,000. Apparently, $594,000 was the cash received. How does all of this information affect the statement of cash flows?

  • A cash inflow of $594,000 is reported within investing activities. It is labeled something like “cash received from sale of equipment.”
  • Depreciation of $230,000 is eliminated from net income in computing the cash flows from operating activities because this expense had no impact on cash flows.
  • In determining the cash flows from operating activities, the $74,000 gain is also eliminated from net income. The $594,000 cash collection comes from an investing activity rather than an operating activity.

Purchase of equipment. According to the information provided, another asset was acquired this year but its cost is not provided. Once again, the accountant must puzzle out the amount of cash involved in the transaction.

The equipment account began the year with a $730,000 balance. The sale of equipment costing $600,000 was just discussed. This transaction should have dropped the ledger account to $130,000 ($730,000 less $600,000). However, at the end of the period, the amount reported for this asset is actually $967,000. How did the cost of equipment rise from $130,000 to $967,000? If no other transaction is mentioned, the most reasonable explanation is that additional equipment was acquired at a cost of $837,000 ($967,000 less $130,000). Unless information is available indicating that part of this purchase was made on credit, the journal entry that was recorded originally must have been made as shown in Figure 17.13 “Assumed Journal Entry for Purchase of Equipment”.

Figure 17.13 Assumed Journal Entry for Purchase of Equipment

At this point, the changes in all related accounts (equipment, accumulated depreciation, depreciation expense, and the gain on sale of equipment) have been used to determine the two transactions for the period and their related cash inflows and outflows. In the statement of cash flows for this company, the investing activities are listed as shown in Figure 17.14 “Statement of Cash Flows—Investing Activities”.

Figure 17.14 Statement of Cash Flows—Investing Activities

Test Yourself

Question:

The following accounts appear on Red Company’s balance sheets at the beginning and end of Year One:

Figure 17.15

During Year One, equipment with an original cost of $30,000 and accumulated depreciation of $18,000 was sold at a loss of $3,000. What is the cash received on the sale of that equipment?

  1. $9,000
  2. $12,000
  3. $15,000
  4. $16,000

Answer:

The correct answer is choice a: $9,000.

Explanation:

The book value of this equipment is $12,000 ($30,000 cost less $18,000 accumulated depreciation). Because the equipment was sold at a loss of $3,000, cash received must have been only $9,000 ($12,000 less $3,000). The transaction can also be recreated through the following entry.

Figure 17.16

The loss is eliminated from income in determining the cash flows from operating activities. If the direct method is used, the loss is simply omitted. If the indirect method is used, the loss (because it is a negative within net income) is added back to net income. The $9,000 cash inflow appears in the investing activity section of the statement of cash flows.

Test Yourself

Question:

The following accounts appear on White Company’s balance sheets at the beginning and end of Year One.

Figure 17.17

One piece of equipment—with an original cost of $30,000 and accumulated depreciation of $18,000—was sold at a loss of $3,000. On a statement of cash flows, what amount should be reported as cash paid for additional equipment bought during the period?

  1. $145,000
  2. $175,000
  3. $205,000
  4. $235,000

Answer:

The correct answer is choice c: $205,000.

Explanation:

Based on the information provided, the equipment account decreased by the $30,000 cost of the asset that was sold. The reported balance would have fallen from $220,000 to $190,000. At year’s end, equipment was not reported as $190,000 but rather as $395,000. With no other transactions mentioned, the $205,000 increase from $190,000 to $395,000 must have been created by purchase of additional equipment. This $205,000 acquisition appears in the investing activities section as a cash outflow.

Test Yourself

Question:

The following accounts appear on Blue Company’s balance sheets at the beginning and end of Year One.

Figure 17.18

Equipment with an original cost of $30,000 and accumulated depreciation of $18,000 was sold at a loss of $3,000. What is the depreciation expense recognized during the year and, if the indirect method is used, how is this reported in the statement of cash flows?

  1. $19,000 is subtracted from net income
  2. $28,000 is added to net income
  3. $34,000 is added to net income
  4. $46,000 is subtracted from net income

Answer:

The correct answer is choice c: $34,000 is added to net income.

Explanation:

Because of the sale of equipment, accumulated depreciation drops by $18,000 from $140,000 to $122,000. By the end of Year One, the account is $156,000. Accumulated depreciation only increases as a result of recording depreciation expense. The increase from $122,000 to $156,000 points to an expense of $34,000. Depreciation is a negative noncash item in net income and is removed in presenting cash flows from operating activities. With the indirect method is used, depreciation is added back.

Determining Cash Flows from Financing Activities

Question: For the year ended January 2, 2011, Johnson & Johnson reported a net cash outflow from financing activities of over $4.9 billion. Within the statement of cash flows, this total was broken down into seven specific categories as replicated in Figure 17.19 “Financing Activity Cash Flows Reported by Johnson & Johnson for Year Ended January 2, 2011”.

Figure 17.19 Financing Activity Cash Flows Reported by Johnson & Johnson for Year Ended January 2, 2011

In preparing a statement of cash flows, how does a company such as Johnson & Johnson determine the amounts that were paid and received as a result of its various financing activities?

 

Answer: As has been indicated, financing activities reflect transactions that are not part of a company’s central operations and involve either a liability or a stockholders’ equity account. Johnson & Johnson paid over $5.8 billion in cash dividends in this year and nearly $2.8 billion to repurchase common stock (treasury shares). During the same period, approximately $7.9 billion in cash was received from borrowing money on short-term debt and another $1.1 billion from long-term debt. None of these amounts are directly associated with the company’s operating activities. However, they do involve either liabilities or stockholders’ equity accounts and are appropriately reported as financing activities.

The procedures used in determining the cash amounts to be reported as financing activities are the same as demonstrated above for investing activities. The change in each relevant balance sheet account is analyzed to determine cash payments and receipts. In starting this process, many liabilities such as accounts payable, rent payable, and salaries payable are ignored because they relate only to operating activities. However, the remaining liabilities and all stockholders’ equity accounts must be studied. The recording of individual transactions can be replicated so that the cash effect is isolated.

To illustrate, various account balances for the Hastings Corporation are presented in the schedule included in Figure 17.20 “Account Balances to Illustrate Cash Flows from Financing Activities”.

Figure 17.20 Account Balances to Illustrate Cash Flows from Financing Activities

In examining the financial records for the Hastings Corporation for this year, the accountant finds several additional pieces of information:

  1. Cash of $400,000 was borrowed by signing a note payable with a local bank.
  2. Another note payable was paid off prior to its maturity date because of a drop in interest rates.
  3. Treasury stock was reissued to the public for cash.
  4. A cash dividend was declared and distributed.

Once again, the various changes in each account balance can be analyzed to determine the cash flows, this time to be reported as financing activities.

Borrowing on note payable. Complete information about this transaction is available. Hastings Corporation received $400,000 in cash from a bank by signing a note payable. Figure 17.21 “Assumed Journal Entry for Signing of Note Payable” provides the journal entry to record the incurrence of this liability.

Figure 17.21 Assumed Journal Entry for Signing of Note Payable

On a statement of cash flows, this transaction is listed within the financing activities as a $400,000 cash inflow.

Paying note payable. Incurring the $400,000 debt raises the note payable balance from $680,000 to $1,080,000. By the end of the year, this account only shows a total of $876,000. The company’s notes payable have decreased in some way by $204,000 ($1,080,000 less $876,000). According to the information gathered by the accountant, a debt was paid off this year prior to maturity. In addition, the general ledger reports a $25,000 loss on the early extinguishment of a debt. When a bond or note is settled before its maturity, a penalty payment is often required. Once again, the journal entry for this transaction can be recreated by logical reasoning as shown in Figure 17.22 “Assumed Journal Entry for Extinguishment of Debt”.

Figure 17.22 Assumed Journal Entry for Extinguishment of Debt

To balance this entry, cash of $229,000 must have been paid. Spending this amount of money to extinguish a $204,000 liability creates the $25,000 reported loss. The cash outflow of $229,000 relates to a liability and is, thus, listed on the statement of cash flows as a financing activity.

Issuance of treasury stock. This equity balance reflects the cost of all repurchased shares. During the year, the total in the T-account fell by $100,000 from $400,000 to $300,000. Apparently, $100,000 was the cost of the company’s shares reissued to the public. At the same time, the capital in excess of cost balance rose from $120,000 to $160,000. That $40,000 increase in contributed capital must have been created by this issuance since no other stock transaction is mentioned. The shares were sold for more than their purchase price. The journal entry must have looked like the one presented in Figure 17.23 “Assumed Journal Entry for Sale of Treasury Stock”.

Figure 17.23 Assumed Journal Entry for Sale of Treasury Stock

If the original cost of the treasury stock was $100,000 and $40,000 was added to the capital in excess of cost, the cash inflow from this transaction had to be $140,000. Cash received from the issuance of treasury stock is reported as a financing activity of $140,000 because it relates to a stockholders’ equity account.

Distribution of dividend. A dividend has been paid to the company’s stockholders, but the amount is not shown in the information provided. However, other information is available. Net income for the period was reported as $200,000. Those profits increase retained earnings. As a result, the beginning balance of $454,000 increases to $654,000. Instead, retained earnings only rose to $619,000 by the end of the year. The unexplained drop of $35,000 ($654,000 less $619,000) must have resulted from the payment of the dividend. No other possible reason is given for this reduction. The appropriate journal entry is found in Figure 17.24 “Assumed Journal Entry for Payment of Dividend”. Hence, a cash dividend distribution of $35,000 is shown within the statement of cash flows as a financing activity.

Figure 17.24 Assumed Journal Entry for Payment of Dividend

In this example, four specific financing activity transactions have been identified as created changes in cash. This section of Hasting’s statement of cash flows can be created in Figure 17.25 “Statement of Cash Flows—Financing Activities”. All the sources and uses of this company’s cash (as related to financing activities) are apparent from this schedule. Determining the cash amounts can take some computational logic, but the information is then clear and useful.

Figure 17.25 Statement of Cash Flows—Financing Activities

Test Yourself

Question:

The Abraham Company begins the year with bonds payable having a reported balance of $600,000. The ending balance is $700,000. This company’s income statement for the year reports a gain on extinguishment of bond of $9,000. During the year, new bonds were issued at their face value of $300,000. How much cash was paid for the bonds that were extinguished?

  1. $191,000
  2. $209,000
  3. $291,000
  4. $309,000

Answer:

The correct answer is choice a: $191,000.

Explanation:

The issuance of $300,000 in new debt would increase the liability balance from $600,000 to $900,000. However, the account ended the year at only $700,000. The unexplained reduction of $200,000 must have been the face value of the debt paid off ($900,000 less $700,000). Because a gain of $9,000 was recognized on this transaction, the company managed to eliminate the debt by paying only $191,000.

Test Yourself

Question:

The Oregon Company’s total stockholders’ equity on January 1 was $870,000. By the end of the year, stockholders’ equity had risen to $990,000. This company bought treasury stock this year. The shares had originally been issued for $120,000 but were reacquired for $150,000. In addition, Oregon reported net income for the year of $340,000. No other stock transactions occurred but a cash dividend was paid. How much should Oregon report on the statement of cash flows for the dividend distribution?

  1. $50,000
  2. $60,000
  3. $70,000
  4. $80,000

Answer:

The correct answer is choice c: $70,000.

Explanation:

Acquisition of the treasury stock reduces stockholders’ equity by $150,000 while net income increases it by $340,000. If nothing else took place, stockholders’ equity at the end of the period would be $1,060,000 ($870,000 less $150,000 but plus $340,000). Instead, the ending total is actually $990,000. Because only the dividend distribution is left to include, it must have been the amount needed to reduce stockholders’ equity to its final reported total ($70,000 or $1,060,000 less $990,000).

Key Takeaway

In determining cash flows from investing activities, current assets such as inventory, accounts receivable, and prepaid rent are ignored because they relate to operating activities. The accountant then analyzes all changes that have taken place in each remaining asset such as buildings and equipment. Hypothetical journal entries can be recreated to replicate the impact of each transaction and lead to the amount of cash involved. For financing activities, a similar process is applied. Liabilities such as accounts payable, interest payable, and salaries payable are not excluded; they only impact operating activities. Monetary changes in the remaining liabilities (notes and bonds payable, for example) and all stockholders’ equity accounts are analyzed. Again, the journal entries that were recorded to report individual events can be recreated so that the cash amounts are known. Once all changes in these accounts have been determined, the various sections of the statement of cash flows can be produced.

Talking with a Real Investing Pro (Continued)

Following is the conclusion of our interview with Kevin G. Burns.

 

Question: Many investors watch the movement of a company’s reported net income and earnings per share and make investment decisions based on increases or decreases. Other investors argue that the amount of cash flows generated by operating activities is really a more useful figure. When you make investing decisions are you more inclined to look at net income or the cash flows generated by operating activities?

Kevin Burns: As I have said previously, net income and earnings per share have a lot of subjectivity to them. Unfortunately, cash flow information can be badly misused also. A lot of investors seem fascinated by the calculation of EBITDA which is the company’s earnings before interest, taxes, depreciation, and amortization. I guess you could say that determining EBITDA is like blending net income and cash flows. But, to me, interest and taxes are real cash expenses so why exclude them? The biggest mistake I ever made as an investor or financial advisor was putting too much credence in EBITDA as a technique for valuing a business. Earnings are earnings and that is important information. A lot of analysts now believe that different cash flow models should be constructed for different industries. If you look around, you can find cable industry cash flow models, theater cash flow models, entertainment industry cash flow models, and the like. I think that is a lot of nonsense. You have to obtain a whole picture to know if an investment is worthwhile. While cash generation is important in creating that picture so are actual earnings and a whole lot of other financial information found in a company’s annual report.

17.5 Appendix: Comprehensive Illustration—Statement of Cash Flows

The Creation of a Complete Statement of Cash Flows

Question: All three sections of the statement of cash flows are presented in this chapter but in separate coverage. Now, through a comprehensive illustration, these categories will be combined into a formal and complete statement.

The following information has been uncovered within the internal records maintained by the Ashe Corporation for Year Seven. The company is a small organization that was incorporated several years ago in the western part of North Carolina.

A few of the significant financial events that occurred during the current year are as follows:

  • Land that had cost Ashe $7,000 several years ago was sold to an outside buyer.
  • A building was also sold but for $210,000 in cash. This property had an original cost of $230,000. Accumulated depreciation to date on this building was $30,000. This building was replaced with a new purchase made for cash during the year.
  • Equipment was purchased for $44,000 in cash to replace other equipment that was sold at the beginning of the year.
  • Additional cash of $110,000 was borrowed on a note payable.
  • Common stock was issued to an investor for cash of $5,000.
  • A cash dividend was declared and paid to the owners near the end of the year.

The accountant for the Ashe Corporation is now attempting to prepare the company’s first complete set of financial statements as part of an application for a new loan. As part of this process, the accountant has created informal balance sheets (Figure 17.26 “Ashe Corporation—Beginning and Ending Balance Sheets for Year Seven”) and an income statement (Figure 17.27 “Ashe Corporation—Income Statement for Year Ended December 31, Year Seven”).

Figure 17.26 Ashe Corporation—Beginning and Ending Balance Sheets for Year Seven

Figure 17.27 Ashe Corporation—Income Statement for Year Ended December 31, Year Seven

A statement of cash flows is now needed for the Ashe Corporation. As shown in Figure 17.26 “Ashe Corporation—Beginning and Ending Balance Sheets for Year Seven”, cash increased from $1,000 to $27,000 during the course of this year. That $26,000 change should be explained. How does a company construct an entire statement of cash flows? Application of the indirect method for presenting operating activities is so prevalent that company officials have decided to use it.

Operating Activities

Answer:

In both the direct and indirect methods, net cash flows from operating activities are derived by following several specific steps:

  1. Start with net income, either the balance for the period (the indirect method) or the income statement as a whole (the direct method). Because the indirect method is being used here, the preparation of the operating activities section begins with Ashe Corporation’s reported net income of $40,000 (from Figure 17.27 “Ashe Corporation—Income Statement for Year Ended December 31, Year Seven”).
  2. Remove noncash expenses. Here, depreciation must be eliminated. This year, the reported amount is $70,000 (buildings) and $30,000 (equipment). As expenses, depreciation is a negative within net income. To remove these two negative amounts, they are added back to the net income figure. Negatives are removed by the inclusion of a positive.
  3. Remove nonoperating gains and losses because they relate to either investing activities or financing activities. Consequently, both the loss on the sale of land ($5,000) and the gain on sale of a building ($10,000) are removed. Neither relates to an operating activity. The loss (a negative) is eliminated by an addition to net income while the gain (a positive) is offset by means of a subtraction.
  4. Convert the remaining revenue and expense balances from accrual accounting to cash accounting by adjusting for changes occurring during the year in related balance sheet connector accounts. The identity of these connector accounts and the amount of each change is reported in Figure 17.28 “Ashe Corporation—Change in Connector Accounts”. The increases and decreases were computed from the beginning and ending balance sheets shown previously in Figure 17.26 “Ashe Corporation—Beginning and Ending Balance Sheets for Year Seven”.

Figure 17.28 Ashe Corporation—Change in Connector Accounts

The change in each of these six connector accounts—accounts receivable, inventory, accounts payable, wages payable, interest payable, and taxes payable—is factored into the computation of cash flows from operating activities to arrive at the actual effect on cash for the period. In this way, the accrual accounting figures reported on the income statement are changed to their cash equivalents.

Accounts receivable—increase of $15,000. A receivables balance can only rise in this manner when more sales are made on credit than cash is collected. The reduction in the cash received causes the receivable to increase. This decrease in cash collections is reflected by subtracting the $15,000 from net income.

Inventory—decrease of $4,000. The inventory balance dropped, which indicates that less inventory was bought this year than was sold. Fewer purchases take less money, keeping the cash balance high. The decrease in inventory and its impact on cash are reported within operating activities through an addition to net income.

Accounts payable—increase of $4,000. Liabilities increase because more debt is acquired than the amount of cash that is paid. Slowness of payment increases accounts payable but also helps keep the company’s cash balance high. This increase in accounts payable is added to net income as another step in arriving at the cash flows from operating activities.

Wages payable—increase of $3,000; interest payable—increase of $1,000. The balance of both of these accrued liabilities went up during this year. Once again, as with accounts payable, an increase in a liability indicates a reduction in payments. This saving of cash is shown when using the indirect method by adding the increases in wages payable and interest payable to net income.

Taxes payable—decrease of $1,000. A liability goes down because cash payments are made that reduce the obligation. However, those payments also shrink the amount of cash held. This effect is mirrored by subtracted the decrease in the liability from net income.

The steps for determining cash flows generated by operating activities have been completed (using the indirect method), and this part of the statement of cash flows can be prepared as shown in Figure 17.29 “Ashe Corporation—Cash Flows from Operating Activities for Year Ended December 31, Year Seven (Indirect Method)”.

Figure 17.29 Ashe Corporation—Cash Flows from Operating Activities for Year Ended December 31, Year Seven (Indirect Method)

As can be seen by comparing Figure 17.29 “Ashe Corporation—Cash Flows from Operating Activities for Year Ended December 31, Year Seven (Indirect Method)” to the company’s income statement (Figure 17.27 “Ashe Corporation—Income Statement for Year Ended December 31, Year Seven”), cash generated by operating activities ($131,000) is considerably higher than the net income reported for that same period ($40,000). Such differences are not uncommon in the business world especially since depreciation is often a large expense that does not require cash.

Investing Activities

After accounting for operating activities, only three asset accounts remain to be examined (along with accumulated depreciation balances where appropriate): land, buildings, and equipment. The accountant analyzes each individually and attempts to recreate the transactions that brought about the various changes during the year.

Land decreased by $7,000 ($21,000 to $14,000). The information provided by the accountant states that land costing $7,000 was sold but does not indicate the amount of cash received. However, the income statement discloses a $5,000 loss on the sale of land. If land costing $7,000 is sold at a loss of $5,000, only $2,000 in cash is received. The journal entry shown in Figure 17.30 “Assumed Journal Entry for Sale of Land” was apparently recorded by Ashe Corporation for this transaction. Land is an asset, so this $2,000 inflow of cash will be reported as an investing activity.

Figure 17.30 Assumed Journal Entry for Sale of Land

Buildings increased by $30,000 ($390,000 to $420,000). According to the introductory information, one building with a cost of $230,000 but a net book value of $200,000 (related accumulated depreciation was identified as $30,000) was sold during this year for $210,000. The company received $10,000 more than net book value which creates the $10,000 gain that appears on the company’s income statement. Because all account balances are known here, the journal entry made by the Ashe Corporation can be replicated in Figure 17.31 “Assumed Journal Entry for Sale of Building”. This transaction will be listed as a $210,000 cash inflow within investing activities on the statement of cash flows.

Figure 17.31 Assumed Journal Entry for Sale of Building

The entry made in Figure 17.31 “Assumed Journal Entry for Sale of Building” does not fully explain the monetary change appearing in the buildings account during this period. This sale drops that account from $390,000 to $160,000 (because of the $230,000 reduction in cost). However, the final balance for the year was not $160,000 but rather $420,000, an increase of $260,000. The introductory information does indicate that a new building was acquired as a replacement. Without mention of any other building transaction, the assumption must be made that this asset was acquired for $260,000 through the entry presented in Figure 17.32 “Assumed Journal Entry for Purchase of Building”. The cash payment will be disclosed on the statement of cash flows as a $260,000 investing activity outflow.

Figure 17.32 Assumed Journal Entry for Purchase of Building

Equipment increased by $14,000 ($36,000 to $50,000). The information provided by the company’s accountant states that one piece of equipment was purchased during the year for $44,000 in cash. This transaction is recorded in Figure 17.33 “Assumed Journal Entry for Purchase of Equipment” and identifies another cash outflow to be reported within the investing activities.

Figure 17.33 Assumed Journal Entry for Purchase of Equipment

This journal entry does not entirely explain the change that occurred in the equipment account. The beginning balance of $36,000 grew to $80,000 as a result of this $44,000 purchase. Yet, the ending balance was just $50,000. Apparently, during the year, another $30,000 reduction ($80,000 less $50,000) took place. Equipment accounts decrease as the result of a sale or some other type of disposal. Equipment was sold this period; its cost must have been the cause of this $30,000 decrease.

In recording the disposal of a long-lived asset, removal of any related accumulated depreciation is also necessary. For the equipment owned by Ashe Corporation, beginning accumulated depreciation was $17,000—a figure that increased by $30,000 due to the depreciation for that year (to a balance of $47,000). However, the ending accumulated depreciation account shows a balance of only $20,000. Another change in this contra account, a reduction of $27,000 ($47,000 less $20,000), still needs to be explained. This figure is the accumulated depreciation for the equipment that was sold. That balance was removed in recording the disposal of this asset.

Because no gain or loss on the disposal of equipment is reported in the income statement, the amount received must have been equal to the $3,000 net book value of the asset ($30,000 less $27,000). With that assumption, the journal entry shown in Figure 17.34 “Assumed Journal Entry for Sale of Equipment” can be constructed. The $3,000 collection will be reported as a cash inflow from an investing activity.

Figure 17.34 Assumed Journal Entry for Sale of Equipment

All changes in the land, buildings, and equipment accounts have now been examined. Each individual transaction was recreated and the change in cash calculated. The investing activity section of the statement of cash flows can then be prepared in Figure 17.35 “Ashe Corporation—Cash Flows from Investing Activities for Year Ended December 31, Year Seven” based on the information that has been gathered.

Figure 17.35 Ashe Corporation—Cash Flows from Investing Activities for Year Ended December 31, Year Seven

Financing Activities

Only three accounts remain unexamined: notes payable, capital stock, and retained earnings. They are either liabilities or stockholders’ equity accounts and, thus, lead to financing activities.

Notes payable increased by $10,000 ($120,000 to $130,000). The information gathered from the company disclosed the signing of a note payable for $110,000 in cash. The journal entry is made in Figure 17.36 “Assumed Journal Entry for Signing of Note Payable”. This transaction is obviously an inflow of that amount of cash that will be reported as a financing activity.

Figure 17.36 Assumed Journal Entry for Signing of Note Payable

According to the beginning and ending balance sheets, notes payable did not actually increase by $110,000 but only by $10,000. Thus, another transaction must have taken place that reduced this liability by $100,000. Except in unusual situations, notes payable only decrease because of cash payments. Because no gain or loss on extinguishment of debt is reported in the income statement, Ashe Corporation must have paid exactly $100,000 to retire that same amount of debt. The journal entry is shown in Figure 17.37 “Assumed Journal Entry for Extinguishment of Note Payable” and the accountant has located another financing activity cash flow (a $100,000 payment).

Figure 17.37 Assumed Journal Entry for Extinguishment of Note Payable

The recording of this second transaction (Figure 17.37 “Assumed Journal Entry for Extinguishment of Note Payable”) leads to the appropriate change in notes payable (the $10,000 account increase was created by $110,000 in additional borrowing and a $100,000 decrease payment).

Capital stock increased by $5,000 ($50,000 to $55,000). The information provided by the accountant states that Ashe Corporation issued stock to an investor for $5,000. This contribution created the change seen in this account, which is recorded in Figure 17.38 “Assumed Journal Entry for Issuance of Capital Stock”. The business received this money and must report a financing activity cash inflow of $5,000. No other stock transactions are indicated for Ashe Corporation.

Figure 17.38 Assumed Journal Entry for Issuance of Capital Stock

Retained earnings increased by $9,000 ($140,000 to $149,000). This final balance sheet account increased by $40,000 because of the net income earned by Ashe Corporation as reported on its income statement. At the end of the year, this amount is closed into retained earnings. The cash flows relating to net income have already been presented within operating activities.

To create the overall change of $9,000, retained earnings must have also declined by $31,000. As mentioned several times in this textbook, other than net income, retained earnings are changed by virtually only one other event: the distribution of dividends. The information provided by the accountant mentions that a dividend was paid this year. That dividend must have caused the remaining $31,000 drop. Net income of $40,000 and a dividend distribution of $31,000 provide the reported increase in retained earnings of $9,000. The dividend entry is presented in Figure 17.39 “Assumed Journal Entry for Payment of Cash Dividend”.

Figure 17.39 Assumed Journal Entry for Payment of Cash Dividend

With this final financing activity, an entire statement of cash flows can be created for the Ashe Corporation in Figure 17.40 “Ashe Corporation—Statement of Cash Flows Year Ended December 31, Year Seven”. All the transactions that affected cash during the current period are included within one of the three categories. Investors and other interested parties can gain a complete picture of the cash results of operations as well as the investing and financing decisions made by management. This portrait provides an excellent complement to the income statement, statement of retained earnings, and balance sheet.

Figure 17.40 Ashe Corporation—Statement of Cash Flows Year Ended December 31, Year Seven

17.6 End-of-Chapter Exercises

Questions

  1. James Hartwell is preparing financial statements for the Ashton Corporation. Hartwell wants these statements to conform to U.S. GAAP so they are more credible with decision makers. Only a balance sheet has been prepared so far. Is Hartwell required to prepare a statement of cash flows according to U.S. GAAP?
  2. As of December 31, Year One, the Midlothian Corporation reports “cash” of $318,455. What might be included in this figure?
  3. As of December 31, Year One, the Midlothian Corporation reports “cash equivalents” of $74,329. What might be included in this figure?
  4. Sashya Douglas is analyzing a statement of cash flows reported by a company that has securities traded on the New York Stock Exchange. Is the direct method or the indirect method more likely to be seen? How can Douglas tell whether the direct method or the indirect method has been applied?
  5. What are the three sections of a statement of cash flows? What types of transactions are included in each of these categories?
  6. During the current year, the Durham Corporation issued 10,000 shares of $1 par value common stock with a stock market value of $18 per share in exchange for 2 acres of land. How is this transaction reported on a statement of cash flows?
  7. A company reports rent expense for the current year of $74,000. Why is this figure not the same as the cash paid by the company for rent?
  8. The Ames Corporation reports salary expense of $875,000. During that period of time, the salary payable balance rose by $39,000. How much cash did the company pay its employees this period?
  9. The Lewiston Corporation reported cost of goods sold of $376,000 for Year One. During that period, its inventory went up by $72,000 while its accounts payable fell by $19,000. How much cash did the company pay for inventory purchases during Year One?
  10. The Clarkson Corporation reported depreciation expense of $107,000 in Year One. In a statement of cash flows where the direct method is applied, how is this expense reported? If the indirect method is applied, how is this expense reported?
  11. For the year ended December 31, Year One, the Maeburry Corporation reports an $85,000 gain on the sale of land. Several acres attached to a warehouse were sold during the year for cash. If cash flows from operating activities are reported by the direct method, how is this gain reported? If the indirect method is applied, how is this gain reported?
  12. During the current year, the Leftowich Company reported that its accounts receivable had gone down while salary payable went up. If the indirect method is applied to determine cash flows from operating activities, how are these changes shown?
  13. The Central Western Corporation reports its cash flows from operating activities by means of the indirect method. In the current year, the company’s prepaid rent account increased by $11,000. At the same time, its accounts payable balance fell by $23,000. If the indirect method is used to present cash flows from operating activities, how are these two changes reported?
  14. The Harbaugh Corporation paid a $39,000 cash dividend this year but also received $11,000 as a dividend from one of the company’s investments. If U.S. GAAP is applied, how are these two transactions reported within a statement of cash flows? If IFRS is applied, how are these two transactions reported within a statement of cash flows?
  15. The Anna Company sells a building with an original cost of $950,000 and accumulated depreciation of $400,000 to another company at a gain of $18,000. What reporting is necessary on a statement of cash flows?
  16. During the current year, a company repurchases 10,000 shares of common stock that were originally issued several years ago for $32 per share. The stock is acquired this year for $37 per share. Later, in the year, 3,000 of these shares are reissued to the public for $40 each. How are these transactions reported in the statement of cash flows for this period?

True or False

  1. ____ A company reports cash equivalents as an asset. The term “cash equivalents” has the same meaning as “cash.”
  2. ____ If the cash flows from operating activities begins with “cash collected from customers,” the indirect method is being applied.
  3. ____ When the direct method of reporting cash flows from operating activities is applied, depreciation expense is added to net income.
  4. ____ When the indirect method of reporting cash flows from operating activities is applied, a loss on the sale of equipment is added to net income.
  5. ____ The Walsingham Corporation reported rent expense of $75,000 this year. At the same time, prepaid rent increased by $9,000. The company paid $84,000 in rent this period.
  6. ____ The Trigger Company reported rent expense of $43,000 this year. At the same time, rent payable increases by $9,000. The company paid $52,000 in rent this period.
  7. ____ A company reports net income for the current year of $200,000. During that year, depreciation expense of $30,000 was reported as well as an $8,000 gain on the cash sale of a building. In addition, accounts receivable increased by $9,000. The net cash flows from operating activities for the period was $213,000.
  8. ____ A company reports cost of goods sold of $500,000. During that period, inventory fell by $34,000 while accounts payable rose by $9,000. The company paid $475,000 in cash this period for the purchase of merchandise.
  9. ____ Purchasing treasury stock is an example of a financing activity.
  10. ____ Significant investing and financing activities not involving cash still need to be disclosed.
  11. ____ During the current year, the Baxter Corporation paid $100,000 on a long-term note payable and $13,000 in related interest expense. According to U.S. GAAP, these two payments must be shown in separate sections of a statement of cash flows.
  12. ____ During the current year, the Frances Corporation paid $200,000 on a long-term note payable and $22,000 in related interest expense. According to IFRS, these two payments must be shown in separate sections of a statement of cash flows.
  13. ____ Equipment costing $320,000 but with accumulated depreciation of $240,000 was sold at a loss of $22,000. The company reports a cash inflow of $58,000 as a financing activity.

Multiple Choice

  1. Where does cash that is collected from customers appear on a statement of cash flows?

    1. Operating activities section
    2. Investing activities section
    3. Financing activities section
    4. Capital activities section
  2. Fritz Corporation began the year with $900,000 in accounts receivable. During the year, sales revenue totaled $7,000,000. Fritz ended the year with $750,000 in accounts receivable. How much cash did Fritz collect from its customers during the year?

    1. $6,850,000
    2. $7,150,000
    3. $7,750,000
    4. $7,900,000
  3. The Willson Company pays off one of its bonds before it came due because interest rates have fallen rather significantly. Where does the cash paid to redeem a bond payable appear on a company’s statement of cash flows?

    1. Operating activities section
    2. Investing activities section
    3. Financing activities section
    4. Capital activities section
  4. Which of the following is true about the reporting of cash flows from operating activities?

    1. Most companies use the indirect method although FASB prefers the direct method.
    2. Most companies use the indirect method because it is preferred by FASB.
    3. Most companies use the direct method because it is preferred by FASB.
    4. Most companies use the direct method, although FASB prefers the indirect method.
  5. During the current year, Rafael Corporation distributed dividends of $23,000, received cash by signing a note payable of $105,000, purchased a piece of equipment for $29,000 in cash, and received dividend income of $12,000. What is reported as Rafael’s net cash inflow from financing activities for the year?

    1. $53,000
    2. $65,000
    3. $82,000
    4. $94,000
  6. Happy Toy Company began Year Nine with $1,000 in inventory and $4,500 in accounts payable. During the year, Happy Toy incurred cost of goods sold of $25,000. Happy Toy ended Year Nine with $2,700 in inventory and $3,800 in accounts payable. How much cash did Happy Toy pay for its merchandise purchases during Year Nine?

    1. $22,600
    2. $24,000
    3. $26,000
    4. $27,400
  7. Crystal Bell Company generated $48,900 in net income during the year. Included in this number are depreciation expense of $13,000 and a gain on the sale of equipment of $4,000. In addition, accounts receivable increased by $16,000, inventory decreased by $5,090, accounts payable decreased $4,330, and interest payable increased $1,200. Based on the above information, what is Crystal Bell’s net cash inflow from operating activities?

    1. $43,860
    2. $48,900
    3. $54,120
    4. $71,940
  8. Transportation Inc. incurred rent expense of $98,000 during the year on a large warehouse. During that same period, prepaid rent increased by $34,000. How much cash did Transportation pay for rent during the year?

    1. $34,000
    2. $64,000
    3. $98,000
    4. $132,000
  9. The Robious Company presents cash flows from operating activities by the direct method. On its income statement for the current year, Robious reports rent expense of $60,000. This figure relates to two different buildings in use by the company. For Building One, prepaid rent went up by $9,000 during the year. For Building Two, rent payable went down by $5,000. How much cash did the company pay this year for rent?

    1. $46,000
    2. $56,000
    3. $64,000
    4. $74,000
  10. A building is bought on October 1, Year One, for $500,000 in cash. It is depreciated using the straight-line method over an expected life of twenty years. A residual value of $20,000 is anticipated. The half-year convention is applied. On April 1, Year Four, the building is sold for cash at a loss of $13,000. Which of the following appears on the company’s Year Four statement of cash flows?

    1. Investing activities cash inflow of $395,000
    2. Investing activities cash inflow of $415,000
    3. Investing activities cash inflow of $428,000
    4. Investing activities cash inflow of $441,000
  11. The Hamster Company determines its cash flows from operating activities by the indirect method. Net income is reported for the current period as $400,000, which included depreciation expense of $70,000 and a gain on sale of land of $30,000. In addition, accounts receivable went down $2,000 during the year while accounts payable went up $7,000. What is the amount of cash generated by the Hamster Company’s operating activities this year?

    1. $431,000
    2. $435,000
    3. $445,000
    4. $449,000
  12. In Year One, the Karsenti Company reported net income of $30,000. Among many other accounts, the income statement included sales revenue of $500,000, cost of goods sold of $300,000, depreciation expense−equipment of $50,000, and a gain on sale of equipment of $23,000. Included on the balance sheet were a number of accounts such as bonds payable (increased $23,000), accounts payable, (decreased $6,000), retained earnings (increased $11,000), equipment (decreased $70,000), accumulated depreciation−equipment (increased $29,000), accounts receivable (decreased $17,000), and inventory (increased $3,000). No capital stock was issued or reacquired during the year. How much cash did this company spend on inventory during the year?

    1. $291,000
    2. $297,000
    3. $303,000
    4. $309,000
  13. Use the same information as presented in problem 12. Using the indirect method, how much cash did Karsenti generate this year from its operating activities?

    1. $57,000
    2. $65,000
    3. $69,000
    4. $71,000
  14. Use the same information as presented in problem 12. One piece of equipment was sold by Karsenti this year for cash, and none was bought. Which of the following is true about this sale of equipment?

    1. It is an investing activity cash inflow of $49,000.
    2. It is an investing activity cash inflow of $63,000.
    3. It is an investing activity cash inflow of $72,000.
    4. It is an investing activity cash inflow of $93,000.
  15. Use the same information as presented in problem 12. Karsenti paid a cash dividend to shareholders this year. How should this distribution be shown on a statement of cash flows?

    1. Operating activity cash outflow of $19,000.
    2. Investing activity cash outflow of $30,000.
    3. Operating activity cash outflow of $30,000.
    4. Financing activity cash outflow of $19,000.

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while the two of you are taking a study break, your roommate asks you the following question: “I was recently looking at the financial statements my parents prepare for their business. I happened to see the statement of cash flows. I studied it more carefully because I was interested in the amount of cash that the business has been making. One of the biggest positive numbers on the entire statement was depreciation expense. It was listed right there under operating activities with a big plus sign. I don’t understand. How are they able to get so much cash from depreciation? I understand how they get cash by selling ice cream, but how does a company get that cash from something called depreciation?” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has grown and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We’ve been having cash flow problems recently. We are making roughly the same net income as in the past, but our cash reserves are shrinking. How can we possibly be selling so much merchandise and making a reasonable profit and still see our cash dwindling? This makes no sense to me. I’m mystified.” How would you respond?

Problems

  1. For each of the following transactions, indicate whether the cash flows are reported in the operating activities section of the statement of cash flows, the investing activities section, or the financing activities section.

    1. Issuance of bonds payable
    2. Cash paid for interest
    3. Cash collected from customers
    4. Paid dividends
    5. Sold equipment for cash
    6. Issued preferred stock for cash
    7. Cash paid for inventory purchases
    8. Purchased a small percentage of the ownership shares of another company
    9. Cash received from dividend income
  2. For each of the following transactions, indicate what is reported on the statement of cash flows and the section in which it is listed. Assume the indirect method is used to present the cash flows from operating activities.

    1. Equipment costing $33,000 but with accumulated depreciation of $14,000 is sold for cash creating a reported gain of $5,000.
    2. A note is signed at the bank on a $200,000 loan.
    3. A building with a cost of $700,000 but a net book value of only $111,000 is destroyed by fire.
    4. A new truck is acquired for $56,000 by signing a long-term note payable.
    5. A new owner invests cash of $49,000 into the business in exchange for 10,000 shares of $1 par value common stock.
    6. The first payment of $11,000 is made on the truck bought in problem 2(d). Of that total, $10,000 is paid on the note with the rest paid as interest.
    7. A building costing $530,000 with accumulated depreciation of $170,000 is sold for cash at a loss of $15,000.
  3. The Starmer Corporation begins the current year with equipment costing $900,000. This figure rises to $1.2 million by the end of the period. Accumulated depreciation was $200,000 on the first of the year but $260,000 at the end. During the year, the following events took place:

    • Equipment costing $450,000 was bought by signing a note for $180,000 and paying cash for the remainder.
    • Depreciation expense recognized for the year on equipment was $110,000.
    • Equipment was sold during the year for cash; a gain of $13,000 was recognized.

    In connection with this company’s equipment account, what will be the effects reported on the statement of cash flows?

  4. Roy Company generated sales during Year Two of $120,000. Roy began the year with $56,000 in accounts receivable and ended the year with $79,000 in accounts receivable. Determine the amount of cash Roy collected from its customers during Year Two.
  5. Below are figures found in the beginning and ending trial balances for the DeFaul Company for Year Three.

      1/1/3 12/31/3
    Equipment $420,000 debit $460,000 debit
    Accumulated depreciation $350,000 credit $370,000 credit
    Note payable $320,000 credit $350,000 credit
    Loss on sale of equipment $24,000 debit

    Additional information:

    • A $50,000 cash payment was made on the note payable this year as well as a $20,000 payment for interest expense.
    • New equipment was bought this year by signing a note payable and making a cash payment.
    • Equipment costing $100,000 but with a net book value of $60,000 was sold for cash.
    • The company uses the indirect method for presenting its cash flows from operating activities.
    1. Based on the previous information, this company has two cash flows that need to be reported as investing activities. What are they and what monetary amount should be included?
    2. Based on the previous information, this company has one cash flow that needs to be reported as a financing activity. What is it and what monetary amount should be included?
  6. The Pasley Company prepares an income statement that reports cost of goods sold of $320,000, rent expense of $30,000, and salary expense of $90,000. During the year, prepaid rent went up $5,000, accounts payable went down $4,000, salary payable went up $3,000, and inventory went down $2,000.

    1. What is the amount of cash the company spent this year to purchase inventory?
    2. What is the amount of cash the company spent this year on rent?
    3. What is the amount of cash the company paid this year to its employees as salaries?
  7. Jamison Company’s income statement for 20X6 is below.

    Figure 17.41 Jamison Company Income Statement as of 12/31/X6

    Figure 17.42 Selected Balance Sheet Accounts from the Beginning and End of 20X6

    Determine Jamison’s net cash inflow or outflow from operating activities for this year using both the direct and indirect methods.

  8. The following information is found in the year-end financial statements reported by Barney Corporation.

    Figure 17.43 Income Statement

    Figure 17.44 Current Asset and Liability Accounts

    Prepare the operating activities section of a statement of cash flows by means of the indirect method.

  9. For each of the following transactions, indicate what is shown on a statement of cash flows as either an investing activity, a financing activity, or an operating activity. What kind of activity is it? Is it a cash inflow or outflow? How much cash is reported?

    1. One thousand shares of $1 per share par value common stock is issued for $19,000.
    2. A cash dividend of $16,000 is distributed to stockholders.
    3. A cash dividend of $9,000 is collected from another company because of the ownership of shares of stock.
    4. A $7,000 payment is made on a long-term note payable with $6,000 reducing the principal and the remaining $1,000 for interest.
    5. A building is sold with a historical cost of $400,000 and accumulated depreciation of $210,000 for cash at a loss of $17,000.
  10. A company creates the following operating activities section of its statement of cash flows.

    Figure 17.45 Company Prepared Operating Activities Cash Flows

    What was the correct amount of cash that was received during this period from the company’s operating activities?

  11. A company computed its cash payments for rent expense for the most recent period as $127,000, as shown next. What was the correct amount of cash the company paid for rent?

    Figure 17.46 Company Computed Payments for Rent

  12. Killian Corporation had several transactions during the year that impacted long-term assets, long-term liabilities, and stockholders’ equity. Determine if the cash amount in each of the following transactions is shown as an investing activity, as a financing activity, or as neither.

    Figure 17.47 Determination of Cash Flow Balances

  13. Ruthers Corporation began business on January 1, 20X5. The financial statements for Ruthers’s first year are given here. Because 20X5 is the first year in business, the balance sheet accounts have no beginning balances.

    Figure 17.48 Ruthers Corporation Income Statement as of 12/31/X5

    Figure 17.49 Ruthers Corporation Balance Sheet 12/31/X5

    Additional Information:

    1. Ruthers purchased land for $14,000 cash.
    2. Common stock was issued for $4,500 in cash.
    3. A note payable was signed for $10,000 cash.

    Prepare Ruthers’s statement of cash flows for 20X5 using the indirect method of calculating cash flows from operating activities.

  14. Looney Company is in the process of preparing financial statements for the year ended 12/31/X9. The income statement as of 12/31/X9 and comparative balance sheets are presented here.

    Figure 17.50 Looney Company Income Statement as of 12/31/X9

    Figure 17.51 Looney Company Balance Sheet December 31, 20X9 and 20X8

    The following additional information has been assembled by Looney’s accounting department:

    1. Equipment was purchased for $90 in cash.
    2. Long-term debt of $70 was issued for cash.
    3. Looney issued eleven shares of common stock for cash during 20X9.

    Prepare Looney’s statement of cash flows as of 12/31/X9 using the direct method.

  15. The following information relates to Henrich’s Hat Store Inc. for the year ended December 31, 20X8.

    Figure 17.52 Henrich’s Hat Store Inc. Balance Sheet, December 31, 20X8

    Figure 17.53 Henrich’s Hat Store Inc. Income Statement for the Year Ended December 31, 20X8

    Other information:

    1. The company purchased a building and fixtures with cash during the year, but none were sold.
    2. Dividends of $170,000 were declared and paid.
    3. Cash proceeds from the sale of common stock totaled $520,000.
    4. Land was purchased for $300,000 cash.

    Prepare the statement of cash flows for Henrich’s Hat Store Inc. for the year ended December 31, 20X8 using the indirect method of calculating cash flows from operations.

Comprehensive Problem

This problem has carried through several chapters, building in difficulty. Hopefully, it has allowed students to continually practice skills and knowledge learned in previous chapters.

In Chapter 16 “In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?”, financial statements for April were prepared for Webworks. They are included here as a starting point for the required recording for May.

This will be your final month of preparing financial statements for Webworks. This month, the statement of cash flows will be added. To simplify the construction of that statement, fewer transactions than usual are included.

Figure 17.54 Webworks Financial Statements

Figure 17.55

Figure 17.56

The following events occur during May:

  1. Webworks starts and completes twelve more sites and bills clients for $9,000.
  2. Webworks purchases supplies worth $140 on account.
  3. At the beginning of March, Webworks had twenty-two keyboards costing $121 each and twenty-eight flash drives costing $25 each. Webworks uses periodic FIFO to cost its inventory.
  4. On account, Webworks purchases eighty-three keyboards for $122 each and ninety flash drives for $26 each.
  5. Webworks sells 98 keyboards for $14,700 and 100 of the flash drives for $3,000 cash.
  6. Webworks collects $9,000 in accounts receivable.
  7. Webworks pays its $500 rent.
  8. Webworks pays off $14,000 of its accounts payable.
  9. Webworks sells all of its shares of QRS stock for $14 per share.
  10. Webworks pays Juan $750 for his work during the first three weeks of May.
  11. Webworks pays off its salaries payable from April.
  12. Webworks pays the owners (Leon Jackson and Nancy Po) a salary of $4,000 each.
  13. Webworks’s note payable permits early payment with no penalty. Leon Jackson and Nancy Po decide to use some of their excess cash and pay off the note and interest payable. The note was paid at the beginning of May, so no interest accrued during May.
  14. Webworks pays taxes of $740 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for May.
    4. Prepare adjusting entries for the following, and post them to your T-accounts.
  15. Webworks owes Juan Marcon (an employee) $200 for his work during the last week of May.
  16. Webworks receives an electric bill for $450. Webworks will pay the bill in June.
  17. Webworks determines that it has $70 worth of supplies remaining at the end of May.
  18. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  19. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method.
  20. The license agreement should be amortized over its one-year life.
  21. Record cost of goods sold.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements, including the statement of cash flows, for May. Prepare the operating section using the indirect method.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in Caribou Coffee Company Inc. The partner is interested in knowing how much money the company has available for growth. The partner also wants to know how much growth has taken place in recent years. The partner asks you to look at the 2010 financial statements for Caribou Coffee by following this path:

  • Go to http://www.cariboucoffee.com.
  • At the bottom of this screen, click on “Our Company.”
  • In the upper right side of the next screen, click on “Investors.”
  • On the left side of the next screen, click on “Financial Reports.”
  • On the next screen, click on “2010 Annual Report” to download.
  • Scroll to page 26 and find the company’s statement of operations (income statement) for the years ended January 2, 2011, and January 3, 2010. Note the amount of net income reported for each year.
  • Scroll down to page 28 and, for each of these two years, note the amount of cash inflow generated by operating activities. Then, look under Investing Activities for the cash outflows labeled as payments for property and equipment.
  1. What net income is reported for each of these two years? Scan the statements of operation to determine any obvious causes for the difference in these two years.
  2. What is the net cash inflow from operating activities for each of these two years? How do each of these numbers compare to the net income figures reported for the same periods of time? Scan the statement of cash flows to determine any obvious causes for the difference in these two years.
  3. In each year, how much cash was spent as payments on property and equipment? What does that say about the growth of the company?

Chapter 16: In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 16 “In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?”.

16.1 Selecting a Legal Form for a Business

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Describe the three primary legal forms available for a business in the United States.
  2. Discuss the advantages and disadvantages of incorporating a business rather than maintaining it as a sole proprietorship or partnership.
  3. Explain the double taxation that is inherent in operating a corporate organization.
  4. Describe the impact that issuing capital stock has on a corporation.

Creating a Corporation

Question: In the United States, businesses and other organizations must operate as one of three legal forms.Over the decades, a number of variations of these legal forms have been allowed, each with its own particular characteristics. For example, limited liability companies (LLC) and limited liability partnerships (LLP) are hybrids that exhibit characteristics of both partnerships and corporations and are permitted to exist in certain states. A proprietorshipA business created, owned, and operated by a single individual; business is not legally separate from its owner; it is also referred to as a sole proprietorship. has a single owner whereas a partnershipAn unincorporated business created, owned, and operated by more than one individual; the business is not legally separate from its owners. is started and owned by two or more parties. In both of these cases, establishing the business is often an unstructured process. For example, a partnership can be created by a mere handshake or other informal agreement.

The third legal form of organization is a corporationAn organization that has been formally recognized by the state government as a separate legal entity so that it can sell ownership shares to raise money for capital expenditures and operations., which is brought into existence by means of a formal request made to a state government. Incorporation creates a separate entity, one that is owned by a group of stockholders. The number of owners is usually not relevant in the operation of a corporation. Because corporations are the dominant legal form (at least monetarily) in the United States, they have been the primary emphasis throughout this text. Numerically, more proprietorships and partnerships do exist but virtually every business of any size operates as a corporation. How is a corporation established, and what characteristics make it attractive?

 

Answer: Organizers only need to satisfy the incorporation process in one state regardless of their entity’s size. To start, they submit articles of incorporation to that government along with any other necessary information.A list of the typical contents of the articles of incorporation can be found at “Articles of Incorporation,” http://en.wikipedia.org/wiki/Articles_of_Incorporation. Rules, regulations, and requirements vary significantly so that these procedures are more complicated in some states than others. For example, many well-known businesses are incorporated in Delaware because of the traditional ease of the laws in that state.

After necessary documents have been filed and all other requirements met, the state government issues a corporate charter that recognizes the organization as a legal entity separate from its owners. This separation of the business from its owners is what differentiates a corporation from a partnership or proprietorship. Following incorporation in one state, the entity is then allowed to operate in any other state.

As mentioned in an earlier chapter, ownership of a corporation is physically represented by shares of stock that are issued to raise funds. In general, these shares are referred to as capital stock and the owners as shareholders or stockholders. For example, by December 31, 2010, Nucor Corporation had issued approximately 375 million of these shares to its stockholders. Unless restricted contractually, capital stock can be exchanged freely. After being issued by a corporation, shares can be resold dozens or even hundreds of times. Operations are usually unaffected by these ownership changes. Information about the current market price of most stocks as well as considerable other information about thousands of businesses can be found at sites such as http://www.google.com/finance and http://www.yahoo.com/finance.

Thus, a corporation is able to continue in existence even after owners die or decide to switch to other investments. In partnerships and proprietorships, capital stock does not exist. Consequently, transfer of an ownership interest is much more complicated. Partnerships and proprietorships often operate only for as long as the original owners are willing and able to continue being actively involved.

As a result of the legal separation of ownership and business, shareholders have no personal liability for the debts of the corporation.When money is loaned to a corporation, especially one that is either new or small, the lender might require the owners to guarantee the debt personally. Unless such a guarantee is made, the debt is that of the corporation and not the members of the ownership. An owner of a share of Nucor Corporation is not responsible for any of the liabilities of that company. Thus, the maximum loss a shareholder can suffer is the amount contributed to the corporation (or paid to a previous owner) in acquiring capital stock. The limited liabilityA legal characteristic associated with the ownership of a corporation whereby the maximum amount of money that can be lost is the owner’s capital investment; an attribute of a corporation that does not exist with the ownership of proprietorships or partnerships. offered by a corporation is one of the primary reasons for its popularity.

In contrast, the owners of a partnership or proprietorship are liable personally for all business debts. No separation exists between the business and ownership. For example, a partner or proprietor could invest $1,000 but wind up losing almost any amount of money if funds are borrowed by the business that cannot be repaid. Such potential losses are especially worrisome in a partnership because of the legal concept of mutual agencyA characteristic of a partnership whereby any partner can obligate other partners to an agreement without their direct consent; does not have a parallel in corporate ownership. where each partner serves as an agent for the entire organization. Thus, a partner can obligate the partnership and, if the debt is not paid when due, the creditor can seek redress from any partner. This possibility of unlimited losses typically restricts the number of potential investors because most people have a strong preference for being able to quantify the amount of risk they face.

The Double Taxation of Corporations

Question: Ownership shares of most corporations can be transferred. Thus, the life of an incorporated business can extend indefinitely as one owner leaves and another arrives. Caswell-Massey Co. is a perfect example. It has been in operation now for over 250 years. According to the corporate Web site (http://www.caswellmassey.com/about/about.aspx), “Before there was the United States of America, there was Caswell-Massey, the original purveyor of the finest personal care products and accessories and America’s oldest operating retailer. The company was founded in Newport, Rhode Island, by Scottish-born Dr. William Hunter in 1752.”

Investors are able to move into and out of corporate investments quickly. In addition, the availability of limited liability restricts potential losses to the amounts invested. These characteristics help explain the immense popularity of the corporate form in the United States. However, a significant number of partnerships and proprietorships continue to be created each year. If no problems existed, incorporation would be the only practical option. What disadvantages are associated with the corporation form?

 

Answer: Incorporation is often a time-consuming and costly legal process. However, in most states, proprietorships and partnerships can be created informally with little effort. Owners of many small businesses may feel that the creation of a corporation is more trouble than it is worth. Furthermore, corporations are often more susceptible to a plethora of government regulations.

The most obvious problem associated with corporations is the double taxationA negative feature associated with the corporate form; corporate earnings are taxed when earned by the business and then taxed again when distributed to owners in the form of dividends. of income. As noted, proprietorships and partnerships are not deemed to be separate entities. Therefore, the owners (but not the business) must pay a tax when any income is generated. However, the income is taxed only that one time when earned by the business.

For a proprietorship, Form 1040 Schedule C is an income statement attached to the owner’s individual income tax return to include the business’s profit or loss. A partnership does file its own tax return on Form 1065, but that is merely for information purposes; no income tax is paid. Instead, the various business revenues and expenses are assigned to the partners for inclusion on their individual tax returns. Any eventual conveyance of this income from the business to the owner does not create a second tax.

In contrast, as separate legal entities, corporations pay their own taxes by reporting all taxable income on Form 1120.Tax rules do allow smaller corporations to file their income taxes as S corporations if certain guidelines are met. S corporations follow virtually the same tax rules as partnerships so that income is only taxed one time when initially earned. However, when any dividends are eventually distributed from those earnings, this transfer is also viewed as taxable income to the stockholders. Income is taxed once when earned by the corporation and again when distributed to the owners. Critics have long argued that the conveyance of the dividend is not a new earning process. To mitigate the impact of this second tax, the U. S. Congress has established a maximum tax rate of 15 percent on much of the dividend income collected by individuals. This rate is considerably lower than that applied to most other types of income (such as salaries). Whether that reduced tax rate for dividends should continue at 15 percent or be raised or lowered is the subject of intense political debate.

To illustrate, assume that income tax rates are 30 percent except for the 15 percent tax on dividends. A proprietorship (or partnership) earns a profit of $100. For this type business, the $100 is only taxable to the owner or owners when earned. Payment of the resulting $30 income tax ($100 × 30 percent) leaves $70 as the remaining disposal income. Any distribution of this money to an owner has no impact on taxes. The government has collected $30.

If a corporation reports income of $100, a tax of $30 is assessed to the business so that only $70 remains. This residual amount can then be conveyed to owners as a dividend. However, if distributed, another tax must be paid, this time by the stockholder. The second income tax is $70 times 15 percent, or $10.50. The owner is left with only $59.50 ($70.00 less $10.50) in disposal income. The government has collected a total of $40.50 ($30.00 plus $10.50). The increase in the amount taken by the government is significant enough to reduce the inclination of many owners to incorporate their businesses.

Test Yourself

Question:

James Erskine and Pamela White are starting a new business. They are trying to determine whether to go to the trouble of incorporating or simply shake hands to form a partnership. Which of the following is a reason to create a partnership?

  1. Partnerships can raise large amounts of money more easily than corporations.
  2. Partnerships offer limited liability for their owners.
  3. Partnerships are not subject to double taxation of income.
  4. Partnerships are more likely to have a continuous life than a corporation.

Answer:

The correct answer is choice c: Partnerships are not subject to double taxation of income.

Explanation:

Because ownership of a corporation is viewed as separate from the business, capital shares can be issued to raise money—often large sums. These shares allow frequent changes in ownership that provides an easy way for a business to exist beyond the life of the original owners. Corporations provide only limited liability for their owners, a major reason for their popularity. However, partnerships are not subject to the same double taxation effect as corporations. The owners save money.

Key Takeaway

Legally, businesses can be created to function as corporations, partnerships, or sole proprietorships. Corporations are formed by meeting the legal requirements of an individual state. In contrast, partnerships and proprietorships can be started with little formal activity. A corporation differs from these other two forms because it is an entity legally separate from its ownership. Because of that separation, the maximum possible loss for the stockholders in a corporation is limited to the amount invested. Without that separation, owners of a partnership or proprietorship face the risk of unlimited liability. Ownership shares of a corporation (capital stock) are issued to raise money for operations and growth. In many cases, these shares can be readily sold by one owner to the next, often on a stock exchange. The ability to buy and sell capital shares enables a corporation to raise funds and have a continuous life. Disadvantages associated with the corporate form include the cost and difficulty of incorporation and government regulation. The double taxation of corporate income (which is not found with partnerships and sole proprietorships) is often the biggest drawback to incorporation. This second tax effect results because dividends are taxed to the recipients, although a reduced rate is often applied.

16.2 The Issuance of Common Stock

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Identify the legal rights normally held by the owners of a corporation’s common stock.
  2. Describe the responsibilities of a board of directors.
  3. Explain the terms “authorized,” “outstanding,” “issued,” and “par value” in relation to common stock.
  4. Record the issuance of common stock for cash.
  5. Record the issuance of common stock for a service or for an asset other than cash.

Common Stock

Question: Several accounts frequently appear in the shareholders’ equity section of a balance sheet reported by a corporation. Each has its own particular meaning. For example, as of January 1, 2011, the Kellogg Company reported the information shown in Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011” (all numbers in millions).

Figure 16.1 Shareholders’ Equity—Kellogg Company as of January 1, 2011

Some of the terms shown in Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011” have been examined previously, others have not.

  • For example, “retained earnings” was described in earlier chapters as the increase in net assets generated as net income over the life of a business less any amounts distributed as dividends during that same period.
  • In the earlier discussion of investments in available for sale securities, “accumulated other comprehensive income” was introduced because this balance sheet category reflected unrealized changes in fair value. For those investments, gains and losses caused by the rise and fall of stock prices are not included within net income. Rather, they are reported within this section of stockholders’ equity.

Common stockA type of capital stock that is issued by every corporation; it provides rights to the owner that are specified by the laws of the state in which the organization is incorporated. has also been mentioned in connection with the capital contributed to a corporation by its owners. As can be seen in Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011”Kellogg communicates additional information about its common stock such as the number of authorized and issued shares as well as par value. What is common stock? Answering this question seems a logical first step in analyzing the information provided by a company about its capital shares.

 

Answer: Common stock represents the basic ownership of a corporation. One survey found that common stock is the only type of capital stock issued by approximately 90 percent of corporations.Matthew Calderisi, senior editor, Accounting Trends & Techniques, 63rd edition (New York: American Institute of Certified Public Accountants, 2009), 299. Obtaining shares of a company’s common stock provides several distinct rights. However, the specific rights are set by the laws of the state of incorporation and do vary a bit from state to state, although the following are typical.Although the Kellogg Company has its headquarters in Battle Creek, Michigan, the company is incorporated in the state of Delaware. Thus, the laws of Delaware set the rights of the common stock shares for this company.

  • Based on state laws and the corporation’s own rules, the owners of common stock are allowed to vote on a few specified issues. By far the most prevalent is the election of the board of directorsA group that oversees the management of a corporation; the members are voted to this position by stockholders; it hires the management to run the company on a daily basis and then meets periodically to review operating, investing, and financing results and also to approve policy and strategy.. As mentioned previously, these individuals represent the ownership of the corporation in overseeing the management. The board of directors meets periodically (annually, quarterly, or as necessary) to review the financial results as well as the future plans and operating strategy developed by management. The board provides guidance and changes where necessary. A list of the individuals (often ten to twenty-five) who serve in this capacity is typically included in a corporation’s annual report, often just after the financial statements.
  • The responsibilities of the board of directors can vary rather significantly from company to company. Some boards do little whereas others are heavily involved in policy making. For example, a note to the financial statements of Starbucks Corporation explained, “We may repurchase shares of Starbucks common stock under a program authorized by our Board of Directors.” Apparently, approval of this particular program fell within the designated responsibilities of the Starbucks board.
  • One of the most important decisions for any board of directors is the declaration of dividends. Management cannot pay dividends to shareholders without specific approval by the board. Dividends cause the company (and specifically its cash balances) to get smaller so careful consideration of the impact must be made before declaration is approved. Stockholders like to receive dividends but do not want the company’s future to be imperiled as the size shrinks.
  • If dividends are paid on common stock, all stockholders share in them proportionally. Although dividends are never guaranteed, the owners must be treated fairly if dividends are distributed. An owner who holds 12 percent of the outstanding common stock is entitled to 12 percent of any dividends paid on common stock. The board of directors cannot reward some common shareholders while ignoring others.
  • Should the company ever be liquidated, the common stock shareholders are entitled to share proportionally in any assets that remain after all liabilities and other claims are settled. Unfortunately, most liquidations result from a severe financial crisis so that holding assets at the end of the process is rare.

Capital Stock Terminology

Question: “Authorized,” “issued,” “outstanding,” and “par value” are terms mentioned by the Kellogg Company in Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011” in describing its ownership shares. What terms are associated with capital stock and what do each of them mean?

 

Answer:

AuthorizedThe maximum number of shares that a corporation can issue based on the articles of incorporation approved by the state government at the time of incorporation.. In applying to the state government as part of the initial incorporation process, company officials indicate the maximum number of capital shares they want to be allowed to issue. This approved limit is the authorized total. Corporations often set this figure so high that they never have to worry about reaching it. However, states normally permit authorization levels to be raised if necessary.

IssuedThe number of shares of a corporation that have been sold or conveyed to owners.. The number of issued shares is simply the quantity that has been sold or otherwise conveyed to owners. According to Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011”Kellogg reports that the state of Delaware authorized one billion shares of common stock, but only about 419 million have actually been issued to stockholders as of the balance sheet date. The remaining unissued shares are still available if the company needs to raise money in the future by selling additional capital stock.

OutstandingThe number of shares of a corporation that are currently in the hands of the public; it is the shares that have been issued since operations first began less any treasury shares repurchased and still held by the corporation.. The total amount of stock currently in the hands of the public is referred to as the shares “outstanding.” Shares are often bought back by a corporation from its stockholders and recorded as treasury stock. Thus, originally issued shares are not always still outstanding. According to the information provided, Kellogg has acquired nearly 54 million treasury shares. Thus, on the balance sheet date, the company has roughly 365 million shares of common stock outstanding in the hands of its stockholders (419 million issued less 54 million treasury shares). This number is quite important because it serves as the basis for dividend payments as well as any votes taken of the stockholders.

Par valueA number printed on a stock certificate to indicate the minimum amount of money owners must legally leave in the business; it is generally set at a low amount to avoid legal complications.. The most mysterious term on a set of financial statements might well be “par value.” Decades ago, the requirement was established in many states that a par value had to be set in connection with the issuance of capital stock. This par value is printed on the face of each stock certificate and indicates (depending on state law) the minimum amount of money that owners must legally leave in the business. By requiring a par value to be specified, lawmakers hoped to prevent the declaration of a cash dividend that was so large it would bankrupt the company, leaving creditors with no chance of repayment. The owners had to leave the set par value in the company.

Traditionally, companies have gotten around this limitation by setting the par value at an extremely low number.Many other laws have been passed over the years that have been much more effective at protecting both creditors and stockholders. For example, Kellogg discloses a par value of $0.25 for its common stock, which is actually quite high. Many companies report par values that fall between a penny and a nickel. The April 30, 2011, balance sheet for Barnes & Noble shows a par value for its common stock of one-tenth of a penny.

Test Yourself

Question:

Several years ago the Catawba Corporation was incorporated. The company was authorized to issue ten million shares of $0.02 par value common stock. Currently, eight million shares remain unissued. In addition, the company is holding 25,000 treasury shares. How many shares are issued and how many shares are outstanding, respectively, for Catawba Corporation?

  1. Issued—18,000,000, Outstanding—1,975,000
  2. Issued—10,000,000, Outstanding—2,000,000
  3. Issued—2,000,000, Outstanding—2,025,000
  4. Issued—2,000,000, Outstanding—1,975,000

Answer:

The correct answer is choice d: Issued—2,000,000, Outstanding—1,975,000.

Explanation:

The Catawba Corporation was authorized to issue ten million shares but still has eight million shares unissued. Apparently, two million have been issued to date. However, 25,000 of these shares were bought back from stockholders as treasury stock. Thus, only 1,975,000 shares are outstanding (in the hands of the stockholders) at the current time.

Reporting the Issuance of Common Stock

Question: Over the years, one residual accounting effect has remained from the legal requirement to include a par value on stock certificates. This figure continues to be used in reporting the issuance of capital stock. Thus, if Kellogg sells one share for cash of $46.00 (the approximate value on the New York Stock Exchange during the fall of 2011), the common stock account is increased but only by its $0.25 par value. Kellogg receives $46.00 but the par value is $0.25. How can this journal entry balance? How does a company report the issuance of a share of common stock for more than par value?

 

Answer: A potential stockholder contributes assets to a company to obtain an ownership interest. In accounting, this conveyance is not viewed as an exchange. It is fundamentally different than selling inventory or a piece of land to an outside party. Instead, the contribution of monetary capital is an expansion of both the company and its ownership. As a result, no gain, loss, or other income effect is ever reported by an organization as a result of transactions occurring in its own stock. An investor is merely transferring assets to a corporation to be allowed to join the ownership.

Consequently, a second shareholders’ equity balance is created to report the amount received from owners above par value. As shown in Figure 16.1 “Shareholders’ Equity—Kellogg Company as of January 1, 2011”Kellogg uses the title capital in excess of par valueA figure that represents the amount received by a corporation from the original issuance of capital stock that is above the par value listed on the stock certificate; it is also referred to as additional paid in capital. but a number of other terms are frequently encountered in practice such as “additional paid-in capital.” Therefore, Kellogg records the issuance of a share of $0.25 par value common stock for $46 in cash as shown in Figure 16.2 “Issuance of a Share of Common Stock for Cash”.A few states allow companies to issue stock without a par value. In that situation, the entire amount received is entered in the common stock account.

Figure 16.2 Issuance of a Share of Common Stock for Cash

On a balance sheet, within the stockholders’ equity section, the amount owners put into a corporation when they originally bought stock is the summation of the common stock and capital in excess of par value accounts. This total reflects the assets conveyed to the business to gain capital stock. For Kellogg, this figure is $600 million as shown in Figure 16.3 “Kellogg Common Stock and Capital in Excess of Par Value, January 1, 2011”. That is the amount of assets received by this company from its owners since operations first began.

As mentioned in a previous chapter, the sales of capital stock that occur on the New York Stock Exchange or other stock markets are between two investors and have no direct effect on the company. Those transactions simply create a change in the ownership.

Figure 16.3 Kellogg Common Stock and Capital in Excess of Par Value, January 1, 2011

Test Yourself

Question:

When incorporated by the state of Nebraska, Stan Company was authorized to issue ten million shares of common stock with a $0.10 par value. At first, one million shares were issued for $5 per share. Later, another four million were issued at $6 per share. What is the amount to be reported as the capital in excess of par value and also as the total of contributed capital?

  1. Capital in Excess of Par Value—$500,000, Contributed Capital—$1,000,000
  2. Capital in Excess of Par Value—$28,500,000, Contributed Capital—$29,000,000
  3. Capital in Excess of Par Value—$28,800,000, Contributed Capital—$30,000,000
  4. Capital in Excess of Par Value—$29,000,000, Contributed Capital—$30,000,000

Answer:

The correct answer is choice b: Capital in Excess of Par Value—$28,500,000, Contributed Capital—$29,000,000.

Explanation:

Stan issued one million shares for $5 each for contributed capital of $5 million. The corporation then issued four million more shares for $6 each or a total of $24 million. Total contributed capital is $29 million ($5 million plus $24 million). Common stock is recorded at the par value of these shares or $500,000 (five million shares issued with a par value of $0.10 each). The remaining $28.5 million of the contribution ($29 million less $500,000) is reported as capital in excess of par value.

Issuing Common Stock in Noncash Exchanges

Question: Common stock is sometimes issued in exchange for property or personal services rather than for cash. Such capital contributions are especially prevalent when a small corporation is first getting started. Potential owners may hold land, buildings, machinery, or other assets needed by the business. Or, an accountant, attorney, engineer, or the like might be willing to provide expert services and take payment in stock. This arrangement can be especially helpful if the business is attempting to conserve cash. What recording is made if common stock is issued for a service or an asset other than cash?

 

Answer: The issuance of stock for a service or asset is not technically a tradeAs mentioned earlier, the issuance of capital stock is not viewed as a trade by the corporation because it merely increases the number of capital shares outstanding. It is an expansion of both the company and its ownership. That is different than, for example, giving up an asset such as a truck in exchange for a computer or some other type of property. but merely an expansion of the ownership. However, the accounting rules are the same. The asset or the service received by the corporation is recorded at the fair value of the capital stock surrendered. That figure is the equivalent of historical cost. It reflects the sacrifice made by the business to obtain the asset or service. However, if the fair value of the shares of stock is not available (which is often the case for both new and small corporations), the fair value of the property or services received becomes the basis for reporting.

To illustrate, assume that a potential investor is willing to convey land with a fair value of $125,000 to the Maine Company in exchange for an ownership interest. During negotiations, officials for Maine offer to issue ten thousand shares of $1 par value common stock for this property. The shares are currently selling on a stock exchange for $12 each. The investor decides to accept this proposal rather than go to the trouble of trying to sell the land.

The “sacrifice” made by the Maine Company to acquire this land is $120,000 ($12 per share × 10,000 shares). Those shares could have been sold to the public to raise that much money. Instead, Maine issues them directly in exchange for the land and records the transaction as shown in Figure 16.4 “Issue Ten Thousand Shares of Common Stock Worth $12 per Share for Land”.

Figure 16.4 Issue Ten Thousand Shares of Common Stock Worth $12 per Share for Land

If this stock was not selling on a stock exchange, fair value might not have been apparent. In that situation, the Maine Company recognizes the land at its own fair value of $125,000 with an accompanying $5,000 increase in the capital in excess of par value account.

Key Takeaway

Common stock forms the basic ownership units of most corporations. The rights of the holders of common stock shares are set by state law but normally include voting for the board of directors, the group that oversees operations and guides future plans. Financial statements often disclose the number of authorized shares (the maximum allowed), issued shares (the number that have been sold), and outstanding shares (those currently in the hands of owners). Common stock usually has a par value although the meaning of this figure has faded in importance over the decades. Upon issuance, common stock is recorded at par value with any amount received above that balance reported in an account such as capital in excess of par value. If issued for a service or asset other than cash, the financial recording is based on the fair value of the shares surrendered. However, if a reasonable estimation of value is not available, the fair value of the asset or service is used.

16.3 Issuing and Accounting for Preferred Stock and Treasury Stock

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Explain the difference between preferred stock and common stock.
  2. Discuss the distribution of dividends to preferred stockholders.
  3. Record the issuance of preferred stock.
  4. Provide reasons for a corporation to spend its money to reacquire its own capital stock as treasury stock.
  5. Account for the purchase and resale of treasury stock when both gains and losses occur.

Differentiating Preferred Stock from Common Stock

Question: Some corporations also issue a second type of capital stock referred to as preferred stockA capital stock issued by some companies that has one or more specified preferences over common shareholders, usually in the form of cash dividends.. Approximately 5–15 percent of the corporations in the United States have preferred stock outstanding but the practice is especially prevalent in certain industries. How is preferred stock different from common stock?

 

Answer: Preferred stock is another version of capital stock where the rights of those owners are set by the contractual terms of the stock certificate rather than state law. In effect, common stockholders voluntarily surrender one or more of their legal rights in hopes of enticing additional investors to contribute money to the corporation. For common stockholders, preferred stock is often another possible method of achieving financial leverage in a manner similar to using money raised from bonds and notes. If the resulting funds can be used to generate more profit than the dividends paid on the preferred stock, the residual income for the common stock will be higher.

The term “preferred stock” comes from the preference that is conveyed to these owners. They are being allowed to step in front of common stockholders when specified rights are applied. A wide variety of such benefits can be assigned to the holders of preferred shares, including additional voting rights, assured representation on the board of directors, and the right to residual assets if the company ever liquidates.

By far the most typical preference is to cash dividends. As mentioned earlier in this chapter, all common stockholders are entitled to share proportionally in any dividend distributions. However, if a corporation issues preferred stock with a stipulated dividend, that amount must be paid before any money is conveyed to the owners of common stock. No dividend is ever guaranteed, not even one on preferred shares. A dividend is only legally required if declared by the board of directors. But, if declared, the preferred stock dividend normally must be paid before any common stock dividend. Common stock is often referred to as a residual ownership because these shareholders are entitled to all that remains after other claims have been settled including those of preferred stock.

The issuance of preferred stock is accounted for in the same way as common stock. Par value, though, often serves as the basis for stipulated dividend payments. Thus, the par value listed for a preferred share frequently approximates fair value. To illustrate, assume a corporation issues ten thousand shares of preferred stock. A $100 per share par value is printed on each stock certificate. If the annual dividend is listed as 4 percent, cash of $4 per year ($100 par value × 4 percent) must be paid on preferred stock before any distribution is made on common stock.

If ten thousand shares of this preferred stock are each issued for $101 in cash ($1,010,000 in total), the company records the journal entry shown in Figure 16.5 “Issue Ten Thousand Shares of $100 Par Value Preferred Stock for $101 per Share”.

Figure 16.5 Issue Ten Thousand Shares of $100 Par Value Preferred Stock for $101 per Share

For recording purposes, companies often establish separate “capital in excess of par value” accounts—one for common stock and one for preferred stock. Those amounts are then frequently combined in reporting the balances within stockholders’ equity.

Test Yourself

Question:

The Gatellan Company wants to acquire a building worth $2 million from Alice Wilkinson. The company does not have sufficient cash and does not want to take out a loan so it offers to issue 90,000 shares of its $1 par value common stock in exchange for the building. Wilkinson wants more assurance of receiving a dividend each year and asks for 18,000 shares of the company’s $100 par value preferred stock paying an annual dividend rate of 5 percent. Eventually, the parties come to an agreement and the Gatellan Company records capital in excess of par value of $200,000. Which of the following happened?

  1. Gatellan issued the common stock but it had no known fair value.
  2. Gatellan issued the common stock and it had a $20 per share fair value.
  3. Gatellan issued the preferred stock and it had no known fair value.
  4. Gatellan issued the preferred stock and it had a $102 per share fair value.

Answer:

The correct answer is choice c: Gatellan issued the preferred stock and it had no known fair value.

Explanation:

In a, the asset is recorded at $2 million, the stock is its $90,000 par value, and the capital in excess is $1.91 million. In b, the asset is recorded at $1.8 million, the stock is its $90,000 par value, and the capital in excess is $1.71 million. In c, the asset is recorded at $2 million, the stock is its $1.8 million par value, and the capital in excess is $200,000. In d, the asset is recorded at $1,836,000, the stock is its $1.8 million par value, and the capital in excess is $36,000.

The Acquisition of Treasury Stock

Question: An account called treasury stockIssued shares of a corporation’s own stock that have been reacquired; balance is shown within the stockholders’ equity section of the balance sheet as a negative amount unless the shares are retired (removed from existence). is often found near the bottom of the shareholders’ equity section of a balance sheet. Treasury stock represents issued shares of a corporation’s own stock that have been reacquired. For example, the September 30, 2011, balance sheet for Viacom Inc. reports a negative balance of over $8.2 billion identified as treasury stock.

An earlier story in the Wall Street Journal indicated that Viacom had been buying and selling its own stock for a number of years: “The $8 billion buyback program would enable the company to repurchase as much as 13 percent of its shares outstanding. The buyback follows a $3 billion stock-purchase program announced in 2002, under which 40.7 million shares were purchased.”Joe Flint, “Viacom Plans Stock Buy Back, Swings to Loss on Blockbuster,” The Wall Street Journal, October 29, 2004, B-2.

Why does a company voluntarily give billions of dollars back to stockholders in order to repurchase its own stock? That is a huge amount of money leaving the company. Why not invest these funds in inventory, buildings, investments, research and development, and the like? Why does a corporation buy back its own shares as treasury stock?

 

Answer: Numerous possible reasons exist to justify spending money to reacquire an entity’s own stock. Several of these strategies are rather complicated and a more appropriate topic for an upper-level finance course. However, an overview of various ideas should be helpful in understanding the rationale for such transactions.

  • As a reward for service, businesses often give shares of their stock to key employees or sell shares to them at a relatively low price. In some states, using unissued shares for such purposes is restricted legally. The same rules do not apply to shares that have been reacquired. Thus, some corporations acquire treasury shares to have available as needed for compensation purposes.
  • Acquisition of treasury stock can be used as a tactic to push up the market price of a company’s stock in order to please the remaining stockholders. Usually, a large scale repurchase (such as made by Viacom) indicates that management believes the stock is undervalued at its current market price. Buying treasury stock reduces the supply of shares in the market and, according to economic theory, forces the price to rise. In addition, because of the announcement of the repurchase, outside investors often rush in to buy the stock ahead of the expected price increase. The supply of shares is decreased while demand is increased. Stock price should go up. Not surprisingly, current stockholders often applaud a decision to buy treasury shares as they anticipate a jump in their investment values.
  • Corporations can also repurchase shares of stock to reduce the risk of a hostile takeover. If another company threatens to buy sufficient shares to gain control, the board of directors of the target company must decide if acquisition is in the best interest of the stockholders.If the board of directors does agree to the purchase of the corporation by an outside party, the two sides then negotiate a price for the shares as well as any other terms of the acquisition. If not, the target might attempt to buy up shares of its own stock in hopes of reducing the number of owners in the market who are willing to sell their shares. Here, repurchase is a defensive strategy designed to make the takeover more difficult to accomplish. Plus, as mentioned previously, buying back treasury stock should drive the price up, making purchase more costly for the predator.

Reporting the Purchase of Treasury Stock

Question: To illustrate the financial reporting of treasury stock, assume that the Chauncey Company has been in business for over twenty years. During that time, the company has issued ten million shares of its $1 par value common stock at an average price of $3.50 per share. The company now reacquires three hundred thousand of these shares for $4 each. How is the acquisition of treasury stock reported?

 

Answer: Under U.S. GAAP, several methods are allowed for reporting the purchase of treasury stock. Most companies use the cost method because of its simplicity. As shown in Figure 16.6 “Purchase of Three Hundred Thousand Shares of Treasury Stock at a Cost of $4 Each”, the acquisition of these shares is recorded by Chauncey at the $1.2 million cost (300,000 shares at $4 each) that was paid.

Figure 16.6 Purchase of Three Hundred Thousand Shares of Treasury Stock at a Cost of $4 Each

Because the money spent on treasury stock represents assets that have left the business, this balance is shown within stockholders’ equity as a negative, reflecting a decrease in net assets instead of an increase.

Except for possible legal distinctions, treasury stock held by a company is the equivalent of unissued stock. The shares do not receive dividends and have no voting privileges.

Reporting the Reissuance of Treasury Stock above Cost

Question: Treasury shares can be held by a corporation forever or eventually reissued at prices that might vary greatly from original cost. If sold for more than cost, is a gain recognized? If sold for less, is a loss reported? What is the impact on a corporation’s financial statements if treasury stock shares are reissued?

To illustrate, assume that Chauncey Company subsequently sells one hundred thousand shares of its treasury stock (shown in Figure 16.6 “Purchase of Three Hundred Thousand Shares of Treasury Stock at a Cost of $4 Each”) for $5.00 each. That is $1.00 more than these shares had cost to reacquire. Is this excess reported by Chauncey as a gain on its income statement?

 

Answer: As discussed previously, transactions in a corporation’s own stock are considered expansions and contractions of the ownership and never impact reported net income. The buying and selling of capital stock are transactions viewed as fundamentally different from the buying and selling of assets such as inventory and land. Therefore, no gains and losses are recorded in connection with treasury stock. As shown in Figure 16.7 “Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $5 per Share”, an alternative reporting must be constructed.

Figure 16.7 Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $5 per Share

The “capital in excess of cost-treasury stock” is the same type of account as the “capital in excess of par value” that was recorded in connection with the issuance of both common and preferred stocks. Within stockholders’ equity, these individual accounts can be grouped into a single balance or reported separately.

Reporting the Reissuance of Treasury Stock below Cost

Question: The first group of treasury shares was reissued for more than cost. Assume that Chauncey subsequently sells another one hundred thousand of treasury shares, but this time for only $2.60 each. The proceeds in this transaction are below the acquisition cost of $4 per share. What recording is made if treasury stock is sold at the equivalent of a loss?

 

Answer: Interestingly, the reissuance of treasury stock for an amount below cost is a transaction not well covered in U.S. GAAP. Authoritative rules fail to provide a definitive rule for reporting such reductions except that stockholders’ equity is decreased with no direct impact recorded in net income. Absolute rules are not always available in U.S. GAAP.

The most common approach seems to be to first remove any capital in excess of cost recorded by the reissuance of earlier shares of treasury stock at above cost. If that balance is not large enough to absorb the entire reduction, a decrease is then made in retained earnings as shown in Figure 16.8 “Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $2.60 per Share”. The $100,000 balance in capital in excess of cost-treasury stock was created in the previous reissuance illustrated in Figure 16.7 “Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $5 per Share”.

Figure 16.8 Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $2.60 per Share

One outcome of this handling should be noted. In earlier chapters of this textbook, “retained earnings” was defined as a balance equal to all income reported over the life of a business less all dividend distributions to the owners. Apparently, this definition is not correct in every possible case. In Figure 16.8 “Sale of One Hundred Thousand Shares of Treasury Stock Costing $4 Each for $2.60 per Share”, the retained earnings balance is also reduced as a result of a stock transaction where a loss occurred that could not otherwise be reported.

Test Yourself

Question:

Several years ago, Ashkroft Inc. issued 800,000 shares of $2 par value stock for $3 per share in cash. Early in the current year, Ashkroft repurchases 100,000 of these shares at $8 per share. A month later, 40,000 of these treasury shares are sold back to the public at $10 per share. What is the total impact on reported shareholders’ equity of these transactions?

  1. $1,920,000 increase
  2. $2,000,000 increase
  3. $2,280,000 increase
  4. $2,420,000 increase

Answer:

The correct answer is choice b: $2,000,000 increase.

Explanation:

The initial issuance of stock increases net assets by $2.4 million (800,000 shares × $3). The purchase of treasury stock reduces net assets by $800,000 (100,000 shares × $8). The reissuance of a portion of the treasury stock increases net assets by $400,000 (40,000 shares × $10). The individual account balances have not been computed here but the overall increase in shareholders’ equity is $2 million ($2.4 million less $800,000 plus $400,000).

Test Yourself

Question:

Several years ago, the Testani Corporation issued 800,000 shares of $2 par value stock for $3 per share in cash. Early in the current year, Testani repurchases 100,000 shares at $8 per share. A month later, 40,000 of these shares are sold back to the public at $10 per share. Several weeks later, after a drop in market price, 50,000 more shares of the treasury stock were reissued for $5 per share. What is the overall impact on reported retained earnings of the reissuance of the 90,000 shares of treasury stock?

  1. No effect
  2. $50,000 reduction
  3. $70,000 reduction
  4. $90,000 reduction

Answer:

The correct answer is choice c: $70,000 reduction.

Explanation:

The first batch of 40,000 shares of treasury stock was sold at $2 above cost, creating a capital in excess of cost account of $80,000. The second batch of 50,000 shares was sold at $3 below cost or $150,000 in total. In recording this second reissuance, the $80,000 capital in excess of cost is first removed entirely with the remaining $70,000 shown as a decrease in retained earnings.

Key Takeaway

A corporation can issue preferred stock as well as common stock. Preferred shares are given specific rights that come before those of common stockholders. Frequently, these rights involve the distribution of dividends. A set amount is often required to be paid before common stockholders can receive any dividends. After issuance, capital stock shares can be bought back by a company from its investors for a number of reasons. For example, repurchase might be carried out in hopes of boosting the stock price. These shares are usually reported at cost and referred to as treasury stock. In acquiring such shares, money flows out of the company so the account appears as a negative balance within stockholders’ equity. When reissued above cost, the treasury stock account is reduced and capital in excess of cost is recognized. To record a loss, any previous capital in excess of cost balance is removed followed by a possible reduction in retained earnings. Net income is not impacted by a transaction in a company’s own stock.

16.4 The Issuance of Cash and Stock Dividends

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Identify the various dates associated with a dividend distribution.
  2. Prepare journal entries to report a cash dividend declaration and payment to stockholders.
  3. Define the characteristics of a cumulative dividend.
  4. Explain a company’s rationale for issuing a stock dividend or stock split.
  5. Record the issuance of a stock dividend

Reporting Dividend Distributions

Question: As stated in an early section of this textbook, a vast majority of investors purchase capital stock for only two reasons: price appreciation and dividend payments. Cash dividends and long-term capital gains (gains on the sale of certain investments that have been held for over one year) are especially appealing to individual investors because they are taxed at a lower rate than most other types of income.

Dividends represent the profits of a business that are being passed along to the owners. Because the corporation is effectively giving away assets, dividends require formal approval by the board of directors. This action is known as a dividend declaration. The board considers current cash balances as well as the projected needs of the business before deciding on the amount, if any, of a dividend payment. How does a corporation report the declaration and distribution of a cash dividend?

 

Answer: Dividends provide a meaningful signal to investors about the financial health of a business. Some corporations even boast about having paid a constant or rising annual dividend for many years. Unfortunately, a number of businesses have been forced recently to reduce or even eliminate their dividend distributions as a result of general economic difficulties. Such decisions typically lead to a drop in the market price of a corporation’s stock because of the negative implications.

Other businesses stress rapid growth and rarely, if ever, pay a cash dividend. The board of directors prefers that all profits remain in the business to stimulate future growth. For example, Google Inc. reported net income of $4.2 billion (2008), $6.5 billion (2009), and $8.5 billion (2010) but paid no dividends in any of those years.

Chronologically, accounting for dividends involves several dates with approximately two to five weeks passing between each:

  • The date of declarationDate on which dividend payments are formally declared (approved) by the board of directors; it is the day on which a liability is recorded by the corporation.
  • The date of recordDate on which stock must be held for a shareholder to be entitled to the receipt of a dividend; the date of record is specified by the board of directors when the dividend is declared. (and the related ex-dividend date)
  • The date of paymentDate on which a cash dividend is distributed to those shareholders who held a corporation’s stock on the date of record; it is also known as the date of distribution. (also known as the date of distribution)

To illustrate, assume that the Hurley Corporation has one million shares of authorized common stock. Since incorporation several years ago, three hundred thousand shares have been issued to the public but twenty thousand were recently bought back as treasury stock. Thus, 280,000 shares are presently outstanding, in the hands of investors. In the current year, Hurley earned a reported net income of $780,000. After some deliberations, the board of directors votes to distribute a $1.00 cash dividend to the owner of each share of common stock.

The day on which Hurley’s board of directors formally decides on the payment of this dividend is known as the date of declaration. Legally, this action creates a liability for the company that must be recognized through the journal entry shown in Figure 16.9 “$1.00 per Share Dividend Declared by Board of Directors, 280,000 Shares Outstanding”. Dividends are only paid on shares that are outstanding so the liability balance is $280,000.

Figure 16.9 $1.00 per Share Dividend Declared by Board of Directors, 280,000 Shares Outstanding

As discussed previously, dividend distributions reduce the amount reported as retained earnings but have no impact on net income.

When the dividend is declared by the board, the date of record is also set. Only the shareholders who own the stock on that day qualify for receipt. The ex-dividend date is the first day on which an investor is not entitled to the dividend. Because receipt of the dividend has been lost, the market price of the stock typically drops by approximately the amount of the dividend on the ex-dividend date (although myriad other market factors influence the movement of stock prices).

No journal entry is recorded by a corporation on either the date of record or the ex-dividend date because they do not represent an event or transaction. Those dates simply allow Hurley to identify the owners to whom the dividend will be paid.

On the date of payment, the corporation mails checks to the appropriate recipients. That is a simple event to record as shown in Figure 16.10 “Payment of $1.00 per Share Cash Dividend”.

Figure 16.10 Payment of $1.00 per Share Cash Dividend

Cumulative Preferred Stock

Question: Assume that Wington Company issues 1,000 shares of $100 par value preferred stock to an investor on January 1, Year One. The preferred stock certificate specifies an annual dividend rate of 8 percent. Thus, dividend payment to the owner is supposed to be $8 per share each year ($100 × 8 percent).

At the end of Year One, Wington faces a cash shortage and the board of directors chooses not to pay this dividend. Have the owners of the preferred shares lost the right to the Year One dividend? Must a corporation report a liability if a preferred stock dividend is not paid at the appointed time?

 

Answer: Preferred stock dividends are often identified on the stock certificate as cumulativeFeature attached to most types of preferred stock so that any dividend payments that are omitted must still be paid before the holders of common stock receive any dividends.. This term indicates that any obligation for unpaid dividends on these shares must be met before dividends can be distributed to the owners of common stock. Cumulative dividends are referred to as “in arrears” when past due.

Thus, if the dividend on the preferred shares of Wington is cumulative, the $8 per share is in arrears at the end of Year One. In the future, this (and any other) missed dividend will have to be paid before any distribution to the owners of common stock can be considered. Conversely, if a preferred stock is noncumulative, a missed dividend is simply lost to those owners. It has no impact on the future allocation of dividends between preferred and common shares.

The existence of a cumulative preferred stock dividend in arrears is information that must be disclosed through a note to the financial statements. However, the balance is not reported as a liability. Only dividends that have been formally declared by the board of directors are recorded through a journal entry.

Test Yourself

Question:

The Hansbrough Company has 20,000 shares outstanding of $100 par value preferred stock with a 6 percent annual dividend rate. This company also has five million shares of $1 par value common stock outstanding. No dividends at all were paid in either Year One or Year Two. Near the end of Year Three, a cash dividend of $400,000 is scheduled to be distributed. If the preferred stock dividend is cumulative, how is this dividend allocated?

  1. Preferred—$ 60,000, Common—$340,000
  2. Preferred—$120,000, Common—$180,000
  3. Preferred—$240,000, Common—$160,000
  4. Preferred—$360,000, Common—$ 40,000

Answer:

The correct answer is choice d: Preferred—$360,000, Common—$ 40,000.

Explanation:

Owners of the preferred stock are entitled to $6 per year ($100 par value × 6 percent) or $120,000 ($6 × 20,000 shares outstanding). Because the preferred stock dividend is cumulative, dividends for Years One and Two are settled first. After those distributions, another $120,000 is paid for Year Three. A total of $360,000 is conveyed to the preferred stockholders. The remaining $40,000 dividend ($400,000 less $360,000) goes to the residual ownership, the holders of the common stock.

Test Yourself

Question:

The Singler Company has 20,000 shares outstanding of $100 par value preferred stock with a 6 percent annual dividend rate. The company also has five million shares of $1 par value common stock outstanding. No dividends at all were paid in either Year One or Year Two. Near the end of Year Three, a cash dividend of $400,000 is scheduled to be distributed. If the preferred stock dividend is noncumulative, how is this dividend distributed?

  1. Preferred—$60,000, Common—$340,000
  2. Preferred—$120,000, Common—$280,000
  3. Preferred—$240,000, Common—$160,000
  4. Preferred—$360,000, Common—$ 40,000

Answer:

The correct answer is choice b: Preferred—$120,000, Common—$280,000.

Explanation:

The preferred stock dividend is noncumulative. Thus, the amounts that were missed during Years One and Two do not carry over into the future. Owners of the preferred stock are only entitled to receive a dividend distribution for the current period ($120,000 or $100 par value × 6 percent × 20,000 shares). The owners of the common stock receive the remainder of the dividend ($280,000 or $400,000 less $120,000).

Distribution of Stock Dividends

Question: A corporate press release issued by Ross Stores Inc. on November 17, 2011, informed the public that “its Board of Directors has approved a two-for-one stock splitA division of each share of outstanding stock to increase the number of those shares; it is a method of reducing the market price of the stock; the process is carried out in hopes that a lower price will generate more market activity in the stock and, therefore, a faster rise in price. to be paid in the form of a 100% stock dividendA dividend distributed to shareholders by issuing additional shares of stock rather than cash; it increases the number of shares outstanding but each owners interest in the company stays the same; as with a stock split, it reduces the price of the stock in hopes of stimulating market interest. on December 15, 2011 to stockholders of record as of November 29, 2011.”

Obviously, as shown by this press release, a corporation can distribute additional shares of its stock to shareholders instead of paying only cash dividends. These shares are issued as a stock dividend or a stock split. Although slightly different in a legal sense, most companies (such as Ross Stores) use the terms “stock dividend” and “stock split” interchangeably.As can be seen in this press release, the terms “stock dividend” and “stock split” have come to be virtually interchangeable to the public. However, minor legal differences do exist that actually impact reporting. Par value is changed to create a stock split but not for a stock dividend. Interestingly, stock splits have no reportable impact on financial statements but stock dividends do. Therefore, only stock dividends will be described in this textbook. No assets are distributed in either scenario—just more shares of the company’s own stock. Are stockholders better off when they receive additional shares of a company’s stock in the form of a stock dividend?

 

Answer: When a stock dividend (or stock split) is issued, the number of shares held by every investor increases but their percentage of the ownership stays the same. Their interest in the corporation remains proportionally unchanged. They have gained nothing.

To illustrate, assume that the Red Company reports net assets of $5 million. Janis Samples owns one thousand of the ten thousand shares of this company’s outstanding common stock. Thus, she holds a 10 percent interest (1,000 shares/10,000 shares) in a business with net assets of $5 million.

The board of directors then declares and distributes a 4 percent stock dividend. For each one hundred shares that a stockholder possesses, Red Company issues an additional 4 shares (4 percent times one hundred). Therefore, four hundred new shares of Red’s common stock are conveyed to the ownership as a whole (4 percent times ten thousand). This distribution raises the number of outstanding shares to 10,400. However, a stock dividend has no actual impact on the corporation. There are simply more shares outstanding. Nothing else has changed.

Janis Samples receives forty of these newly issued shares (4 percent times one thousand) so that her holdings have grown to 1,040 shares. After this stock dividend, she still owns 10 percent of the outstanding stock of Red Company (1,040/10,400), and the company still reports net assets of $5 million. The investor’s financial position has not improved. She has gained nothing as a result of the stock dividend.

Not surprisingly, investors make no journal entry in accounting for the receipt of a stock dividend. No change has taken place except for the number of shares held.

However, the corporation does make a journal entry to record the issuance of a stock dividend although distribution creates no impact on either assets or liabilities. The retained earnings balance is decreased by the fair value of the shares issued while contributed capital (common stock and capital in excess of par value) is also increased by this same amount. Fair value is used here because the company could have issued those new shares for that amount of cash and then paid the money out as a dividend. Issuing a stock dividend creates the same overall impact.

One exception to this method of reporting is applied. According to U.S. GAAP, if a stock dividend is especially large (in excess of 20–25 percent of the outstanding shares), the change in retained earnings and contributed capital is recorded at par value rather than fair value.A stock dividend of between 20 and 25 percent can be recorded at either fair value or par value. When the number of shares issued becomes this large, fair value is no longer viewed as a reliable indicator of the financial effect of the distribution.

Test Yourself

Question:

The Hazelton Corporation has 600,000 shares outstanding of $2 per share par value common stock that was issued for $5 per share but currently trades on a stock market for $9 per share. The board of directors opts to issue a 3 percent stock dividend. What will be the reported reduction in retained earnings as a result of this action?

  1. Zero
  2. $36,000
  3. $126,000
  4. $162,000

Answer:

The correct answer is choice d: $162,000.

Explanation:

As a small stock dividend (under 20–25 percent of the outstanding shares), retained earnings is decreased by the fair value of the shares issued while contributed capital goes up by the same amount. Hazelton issues 18,000 new shares (3 percent of 600,000) with a fair value of $9 each or $162,000 in total (18,000 × $9). The par value is only $36,000 (18,000 × $2) with the difference recorded as capital in excess of par value. The journal entry to record this stock dividend is as follows.

Figure 16.11

Test Yourself

Question:

The Pitino Corporation has 600,000 shares outstanding of $2 per share par value common stock that was issued for $5 per share but currently trades for $9 per share. The board of directors opts to issue a 60 percent stock dividend. What will be the reported reduction in retained earnings?

  1. $360,000
  2. $720,000
  3. $2,520,000
  4. $3,240,000

Answer:

The correct answer is choice b: $720,000.

Explanation:

As a large stock dividend (over 20–25 percent of the outstanding shares), retained earnings is decreased by the par value of the shares issued while contributed capital goes up by the same amount. Pitino issues 360,000 new shares (60 percent of 600,000) with a par value of $2 each or $720,000 in total (360,000 × $2). The journal entry to record this stock dividend is as follows.

Figure 16.12

Why Issue a Stock Dividend?

Question: If no changes occur in the makeup of a corporation as the result of a stock dividend, why does a board of directors choose to issue one?

 

Answer: The primary purpose served by a stock dividend (or a stock split) is a reduction in the market price of the corporation’s capital stock. When the price of a share rises to a relatively high level, fewer investors are willing to make purchases. At some point, market interest wanes. This reduction in demand will likely have a negative impact on the stock price. A growing business might find that a previously escalating trend in its market value has hit a plateau when the price of each share rises too high.

By issuing a large quantity of new shares (sometimes two to five times as many shares as were outstanding), the price falls, often precipitously. For example, an investor who held one hundred shares at a market price of $120 per share (total value of $12,000) might now own two hundred shares selling at $60 per share or three hundred shares selling at $40 per share (but with the same total market value of $12,000). The stockholder’s investment remains unchanged but, hopefully, the stock is now more attractive to potential investors at the lower price so that the level of active trading increases.

Stock dividends also provide owners with the possibility of other benefits. For example, cash dividend payments usually drop after a stock dividend but not always in proportion to the change in the number of outstanding shares. An owner might hold one hundred shares of common stock in a corporation that has paid $1 per share as an annual cash dividend over the past few years (a total of $100 per year). After a 2-for-1 stock dividend, this individual now owns two hundred shares. The board of directors might then choose to reduce the annual cash dividend to only $0.60 per share so that future payments go up to $120 per year (two hundred shares × $0.60 each). Such a benefit, though, is not guaranteed. The investors can merely hope that additional cash dividends will be received.

Key Takeaway

Many corporations distribute cash dividends after a formal declaration is passed by the board of directors. Journal entries are required on both the date of declaration and the date of payment. The date of record and the ex-dividend date are important in identifying the owners entitled to receive the dividend but no transaction occurs. Hence, no recording is made on either of those dates. Preferred stock dividends are often cumulative so that any dividends in arrears must be paid before a common stock distribution can be made. Dividends in arrears are not recorded as liabilities until declared although note disclosure is needed. Stock dividends and stock splits are issued to reduce the market price of capital stock and keep potential investors interested in the possibility of acquiring ownership. A stock dividend is recorded as a reduction in retained earnings and an increase in contributed capital. However, stock dividends have no direct impact on the financial condition of either the company or its stockholders.

16.5 The Computation of Earnings per Share

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Compute and explain return on equity.
  2. Discuss the reasons that earnings per share (EPS) figures are so closely watched by investors.
  3. Calculate basic EPS with or without the existence of preferred stock.
  4. Explain the relevance of the P/E ratio.
  5. Identify the informational benefit provided by diluted EPS.

The Calculation of Return on Equity

Question: Throughout this textbook, various vital signs have been presented. They include ratios, numbers, percentages, and the like that are commonly studied by decision makers as an indication of current financial health and future prosperity. One common measure is return on equity (ROE)Ratio computed to measure the profitable use of a business’s resources; it is determined by dividing net income by average stockholders’ equity for the period.How does an interested party calculate the return on equity reported by a business?

 

Answer: Return on equity reflects the profitability of a business based on the size of the owners’ claim to net assets. It is simply the reported net income divided by average stockholders’ equity for the period.

return on equity = net income/average stockholders’ equity

For example, PPG Industries Inc. began 2010 with total stockholders’ equity of $3,922 million. Partly because of a large acquisition of treasury stock and the payment of a $360 million cash dividend, the company ended that year with stockholders’ equity of only $3,833 million. For the year ended December 31, 2010, PPG reported net income of $880 million for a return on equity of 22.7 percent.

average stockholders’ equity: ($3,922 million + $3,833 million)/2 = $3,877.5 million return on equity: $880 million/$3,877.5 million = 22.7%

As with all such vital signs, the strength or weakness of PPG’s 22.7 percent return on equity is difficult to evaluate in isolation. Comparison with other similar companies can be very helpful as is the trend for this particular company over time. For example, decision makers looking at PPG were likely to be particularly impressed with the 2010 return on equity after learning that the 2009 return on equity was 11.5 percent.

Earnings per Share and the P/E Ratio

Question: No single “vital sign” that is computed to help investors analyze a business and its financial health is more obsessively watched than earnings per share (EPS). Corporations even call press conferences to announce their latest EPS figures. According to U.S. GAAP, public companies are required to present EPS for each period that net income is reported. As just one example, Pfizer Inc. disclosed basic EPS of $1.03 on its income statement for the year ended December 31, 2010. Why is the EPS reported by a corporation so closely monitored by the investment community?

 

Answer: The simple reason for the public fascination with EPS is that this number is generally considered to be linked to the market price of a company’s capital stock. Therefore, constant and wide-scale speculation takes place about future EPS figures as a technique for forecasting future stock prices. If analysts merely predict an increase in EPS, this forecast alone can lead to a surge in the traded price of a company’s shares.

price-earnings ratio (P/E ratio)A ratio computed by dividing the current market price of an entity’s stock by the latest earnings per share balance; it is used to help predict future stock prices based on anticipated EPS figures. is even computed to help quantify this relationship. The P/E ratio is the current price of the stock divided by the latest EPS figure. It enables investors to anticipate movements in the price of a stock based on projections of earnings per share. If a company’s P/E ratio is twenty and is expected to remain constant, then an increase in EPS of $1 should lead to a $20 rise in stock price.

Theories abound as to how P/E ratios should be used. Some investors only buy capital shares of companies with high P/E ratios. They believe the P/E ratio indicates businesses that the stock market has assessed as particularly strong with excellent future prospects. Other investors prefer companies with low P/E ratios because those stocks may well be undervalued by the market with more room for the price to grow.

Figure 16.13 As of November 23, 2011, the P/E ratio for Several Prominent Companies

The ongoing debate as to whether EPS and the P/E ratio are over emphasized as investing tools is a controversy better left to upper-level finance courses. The fascination is certainly real regardless of whether the perceived benefits are as great as many decision makers believe.

Calculating Earnings per Share

Question: EPS is obviously a much analyzed number in a set of financial statements. How is EPS calculated?

 

Answer: EPS is a common stock computation designed to measure operating results after all other claims have been satisfied. In simplest form, EPS (often referred to as basic EPSA figure that must be reported by corporations that have their stock publicly traded; it is net income less preferred stock dividends divided by the weighted-average number of shares of common stock outstanding during the period.) is the net income for the period divided by the weighted average number of outstanding shares of common stock. The computation allocates a company’s income equally to each of its shares.

To illustrate, assume the Maris Company reports its most recent net income as $700,000. If the company has a weighted average of 200,000 shares of common stock outstanding for this period of time, EPS is $700,000/200,000 or $3.50 per share. Furthermore, if the market price of Maris Company stock is $35, then the P/E ratio is 35/3.50, or ten.

Because EPS only relates to common stock, this computation is altered slightly if any preferred stock shares are also outstanding. Preferred stock is normally entitled to a specified dividend before common stock has any claim. However, most preferred stocks get nothing other than that dividend. Therefore, in determining basic EPS, any preferred stock dividend must be removed to arrive at the portion of income that is attributed to the ownership of common stock.

Basic EPS (net income – preferred stock dividend)/average number of common shares outstanding

Test Yourself

Question:

Daryl Corporation’s net income for the current year is reported as $450,000. Preferred stock dividends for the same period amount to $10,000. On January 1, 100,000 shares of common stock were outstanding. On July 1, 20,000 additional shares of common stock were issued. What is Daryl’s EPS?

  1. $3.67
  2. $4.00
  3. $4.40
  4. $4.50

Answer:

The correct answer is choice b: $4.00.

Explanation:

The income attributed to common stock is $440,000, the reported balance of $450,000 less the $10,000 preferred stock dividend. The weighted average number of outstanding common shares for this year was 110,000. The company had 100,000 shares of common stock outstanding during the first six months and 120,000 shares for the second six months.

Figure 16.14

Test Yourself

Question:

The latest income statement for the St. John Corporation reports net income of $828,000. Preferred dividends for the period were $30,000. On January 1, 200,000 shares of common stock were outstanding. However, on October 1, 40,000 shares of this common stock were repurchased as treasury stock. What is St. John’s basic EPS?

  1. $3.28
  2. $3.78
  3. $4.20
  4. $4.73

Answer:

The correct answer is choice c: $4.20.

Explanation:

The income attributed to common stock is $798,000, the reported balance of $828,000 for the period less the $30,000 preferred stock dividend. The weighted average number of outstanding common shares for this year was 190,000. The company had 200,000 shares of common stock outstanding during the first nine months of the year but only 160,000 shares for the final three months (as a result of buying back the shares of treasury stock).

Figure 16.15

Diluted Earnings per Share

Question: For the year ended March 31, 2011, the McKesson Corporation reported basic EPS of $4.65 per share. However, this company also reported a second figure, diluted EPS, which was only $4.57 per share. What is the meaning of diluted EPS? Why is diluted EPS also reported by some businesses along with basic EPS?

 

Answer: All publicly traded companies must disclose basic EPS. Income reported for the period (after removal of any preferred stock dividends) is allocated evenly over the weighted average number of shares of outstanding common stock. Basic EPS is a mechanically derived figure based on the historically reported income and number of shares outstanding.

Many corporations also have other contractual obligations outstanding that could become common stock and, therefore, potentially affect this computation. Stock options, convertible bonds, and convertible preferred stock can each be exchanged in some manner for common stock shares. The decision to convert is usually up to the holder and out of the control of the company. If these conversions ever take place, the additional shares could cause EPS to drop—possibly by a significant amount. This potential reduction should be brought to the attention of investors.

Diluted EPSHypothetical computation that reduces basic earnings per share to reflect the possible decrease if outstanding convertible items are actually turned into common stock; it includes the potential impact of stock options, convertible bonds, convertible preferred stock, and the like to warn decision makers of the “worst case scenario” if those convertibles are ever turned into common stock. serves as a warning to decision makers of the possible impact that the existence of convertibles can have on ownership. It provides a “worst case scenario” by setting up a hypothetical computation to give weight to the possibility of such conversions. Because of the complicated steps that are involved, the actual mechanical process is better left to an intermediate accounting course. However, an understanding of the purpose of reporting diluted EPS is worthwhile at the introductory level.

Stock options, convertible bonds, convertible preferred stocks, and the like could become common stock and reduce a company’s reported EPS. Thus, U.S. GAAP requires that this possible impact is calculated and shown by the reporting of a lower diluted EPS. For the McKesson Corporation, if all other transactions stayed the same except that its convertible items were exchanged for common stock, basic EPS would fall from $4.65 to $4.57. That is the possible dilution that could be caused by the presence of items convertible into common stock. For an investor or potential investor, that is information of interest. Including this figure alerts decision makers to the possibility of such conversions and helps them quantify the potential impact.

Key Takeaway

Return on equity (ROE) is a percentage often computed by financial analysts to help evaluate the profitability of a business. It is net income divided by the average stockholders’ equity for that period of time. Likewise, the reporting of earnings per share (EPS) draws an especially wide circle of interest. EPS is considered by most decision makers who are looking at a particular business. Basic EPS must be reported by every publicly traded company for each year in which net income is reported. It is the net income for the period divided by the weighted average number of common stock shares outstanding. Because EPS is only determined for common stock, any preferred stock dividends must be removed from net income as a preliminary step in this computation. The resulting EPS figure is viewed as having a major impact on the movement of the company’s stock price. The price-earnings (P/E) ratio even quantifies that effect. If a corporation also has items such as stock options or convertible bonds that can be turned into common stock, their conversion could potentially have an adverse impact on EPS. Thus, if a company has any convertibles outstanding, diluted EPS must also be reported to help investors understand the possible negative impact that might result from future conversions.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: Investors in the United States seem to have an obsession about the reporting of earnings per share (EPS). Even slight movements in projected EPS figures can create significant swings in the market price of a company’s stock. Do you think there is an overemphasis on EPS in the public’s investing decisions? How closely do you pay attention to the EPS figures that are reported by the businesses that you are following?

Kevin Burns: This is a very good question. By now students should realize that accounting is really all about estimates. Although investors would like accounting to be objectively exact, reporting such estimates really requires an awful lot of subjectivity. For example, for many years, General Electric would almost always report EPS a penny or two above market expectations. This was quarter after quarter like clockwork. It got to the point where if the company didn’t “beat” the estimates on the street by a penny or two, the market was disappointed. It is absurd to believe that this is meaningful. This is especially true when earnings can also be managed simply by delaying or speeding up a major transaction from one time period to another. I believe that EPS, although important, is not the ultimate piece of information that some investors seem to think. I am much more concerned about asset values, growth prospects, and what a company does with the cash it is able to generate.

16.6 End-of-Chapter Exercises

Questions

  1. What are the three legal forms of business found in the United States?
  2. Art Heyman and Jeff Mullins create a new business that they form as a partnership. Why might they have decided not to incorporate their business?
  3. Hans Iverson forms a business that earns income of $600,000 in the current year. He paid himself $400,000 purely as a reward for ownership (not a salary). How are this income and this distribution taxed if the business is formed as a sole proprietorship? How are this income and this distribution taxed if the business is formed as a corporation?
  4. Jack and Jill form a business by each contributing $30,000 in cash. Jack then borrows $1 million for the business from the local bank. Unfortunately, the money is lost through a series of bad investments. If this business is formed as a corporation, what is the impact of this loss on Jill? If this business is formed as a partnership, what is the impact of this loss on Jill?
  5. Arthur C. Clarke bought one share of common stock in HAL Computing on the New York Stock Exchange. What rights does Clarke gain as a result of this ownership?
  6. Wilson Beckett buys a share of common stock directly from Anston Corporation for $13 in cash. Several weeks later, Beckett sells this share to Buddy O’Coron for $22 in cash. What is the impact on Anston of each of these transactions?
  7. The Amskan Corporation issues common stock to several investors. On the stock certificate, a par value of $1.00 per share is listed. What is the significance of this par value figure?
  8. Hogsdon Corporation was incorporated in the state of Delaware although its operations are carried out entirely in the state of Vermont. On its balance sheet, the company indicates that it has 300 million shares of common stock authorized, 188 million issued, and 174 million outstanding. What do each of these terms mean?
  9. Company PR issues 1,000 shares of common stock with a $2.00 per share par value to investors for cash of $9.00 per share. What journal entry does the company record for this transaction?
  10. Company PR issues 1,000 shares of common stock with a $2.00 per share par value and a $9.00 per share fair value to investors for a tract of land that has a fair value of $10,000. What journal entry does the company record?
  11. Over the years, the Boyer Corporation has issued thousands of shares of its common stock. It has also bought back some of these shares as treasury stock and then reissued them later. Under what conditions do these transactions affect the company’s reported net income?
  12. Mike Lewis and Warren Chapman each own 50 percent of the common stock of MlWc Corporation. Ron Wyskowski wants to become an owner, so he contributes $50,000 in cash to the business for 1,000 shares of preferred stock. How might these preferred shares be different from the company’s common stock? Why might the original owners have wanted to issue preferred shares rather than common shares to Wyskowski? Why might Wyskowski have wanted to acquire preferred shares rather than common shares?
  13. The Vylon Corporation wants to buy enough shares of the Bitsey Corporation to gain control of its operations. Upon hearing this news, the board of directors of Bitsey immediately authorizes the purchase of 3 million shares of its common stock. Why is the company acquiring its own treasury stock?
  14. The common stock of Orlent Corporation has been selling for approximately $14 per share for the past year. Stockholders are upset that the stock price has not risen for such an extended period of time. On January 19 of the current year, the board of directors authorizes the purchase of 11 million share of the company’s own stock. Why was this action most likely taken?
  15. A press release issued by Mason-Williams Corporation provides the following information: “On March 17, the company’s Board of Directors declared a $0.60 per share cash dividend on the company’s common stock to be paid to all owners on record as of March 29 with distribution on April 11.” The company has 20 million shares authorized, 6 million shares issued, and 5 million shares outstanding. Make all journal entries for this cash dividend including the dates.
  16. The CarlB Corporation has 30,000 shares of common stock issued and outstanding. It also has 2,000 shares of $100 par value preferred stock issued and outstanding that pays an annual 4 percent cash dividend. The dividend is neither declared nor paid in Year One. What reporting is necessary on the Year One financial statements if this preferred stock dividend is cumulative? What reporting is necessary on the Year One financial statements if this preferred stock dividend is noncumulative?
  17. The MWF Corporation has 40,000 shares of common stock issued and outstanding. It also has 5,000 shares of $100 par value preferred stock issued and outstanding that pays an annual 6 percent cumulative cash dividend. No cash dividends are declared or paid in Year One but an $80,000 cash dividend is declared and paid in Year Two. How much of this cash will each share of common stock receive in Year Two?
  18. A company has 100,000 shares outstanding at January 2, Year One. The company reports assets of $1.4 million and liabilities of $500,000. The company’s stock is selling for $20 per share just before it issues a 20 percent dividend. Susan Marie Fonseca owns 8,000 shares of the company’s stock before the dividend. What journal entry does she make when she receives the additional 1,600 shares? Why is this reporting necessary?
  19. What benefit does an owner hope to receive when a corporation issues a stock dividend or a stock split?
  20. The Lion Corporation has shares of $2 par value common stock outstanding that are currently selling for $29 per share. The company issues 35,000 new shares as a stock dividend. What is the reduction to be recorded in retained earnings if this issuance is a 10 percent stock dividend? What is the reduction to be recorded in retained earnings if the issuance is a 40 percent stock dividend?
  21. In Year One, the Marstale Corporation reports a return on equity (ROE) of 14.7 percent. In Year Two, the ROE is 18.2 percent. How is ROE computed? What information is provided by a company’s ROE?
  22. A company has both common stock and preferred stock outstanding. Each of these stocks paid a cash dividend in the current year. How is basic earnings per share (EPS) computed?
  23. A company reports net income of $300,000 for Year One. It started this year with 120,000 shares of common stock outstanding. However, on April 1, another 20,000 shares were issued to the public for cash. What should be reported as basic EPS?
  24. A company reports a price-earnings ratio (P/E ratio) of 14.6. How is that figure determined? How might investors make use of this number?
  25. The Jacston Corporation reports basic EPS of $3.80 but diluted EPS of $2.90. In general, how is diluted EPS computed? What is the significance of diluted EPS to investors?

True or False

  1. ____ Sole proprietorships are easier to form than corporations.
  2. ____ Most businesses of any significant size are formed as corporations.
  3. ____ Limited liability is a concept that applies to a corporation but not to a partnership.
  4. ____ Mutual agency is a concept that applies to a corporation but not to a partnership.
  5. ____ All corporations in the United States have both common stock and preferred stock.
  6. ____ Par value is a term used to indicate the market value of a share of capital stock.
  7. ____ The management of a corporation appoints the board of directors.
  8. ____ If a company has 80,000 shares of common stock issued but only 70,000 shares outstanding, the company holds 10,000 shares of its own treasury stock.
  9. ____ If a company has 80,000 shares of common stock issued but only 70,000 shares outstanding and a $1.00 per share dividend is declared, retained earnings is reduced on that date by $80,000.
  10. ____ A company is going to pay a cash dividend. The liability for that dividend is first reported on the date of record.
  11. ____ The Yelson Company has 20,000 shares of $50 par value preferred stock authorized but only 9,000 shares issued and outstanding. This preferred stock pays a 4 percent annual cash dividend that is cumulative. The dividend is missed in both Year One and Year Two. A liability for $36,000 should be reported on the December 31, Year Two, balance sheet.
  12. ____ Jayne Wellsfield owns 10,000 shares of Hartlan Corporation that she bought for $16 per share. She sells this entire investment to Robert Cranston for $23 per share. This transaction has no financial impact on Hartlan.
  13. ____ The Robertsen Corporation issues 4,000 shares of $3 par value common stock (with a fair value of $9 per share) in exchange for eight acres of land worth $5,000 per acre. Robertsen should report a gain as a result of this transaction.
  14. ____ The Cordol Corporation issues 10,000 shares of its $2 par value common stock for $9 cash per share. Later, the company reacquires 2,000 shares of this stock for $10 per share. The cost method is used to record these shares. Cordol records this acquisition as an asset with a reported value of $20,000.
  15. ____ The Lodroc Corporation issues 30,000 shares of its $1 par value common stock for $13 cash per share. Later, the company reacquires 4,000 shares of this stock for $15 per share. The cost method is used to record these shares. The treasury stock is reissued at $16 per share. Net income is not affected by either the reacquisition or the reissuance of these shares.
  16. ____ On the ex-dividend date, the price of a company’s stock on a stock exchange will have a tendency to fall.
  17. ____ A company declares a cash dividend on December 18, Year One to be paid on January 22, Year Two. Working capital decreases in Year One but is not affected in Year Two.
  18. ____ A cumulative dividend on preferred stock must be paid each year or a company can be forced into bankruptcy.
  19. ____ An investor receives 1,000 shares of stock valued at $7 per share as a stock dividend. Dividend revenue of $7,000 should be recognized.
  20. ____ The Westling Corporation is trying to decide whether to issue a 15 percent stock dividend (15,000 new shares) or a 30 percent stock dividend (30,000 new shares). The 30 percent stock dividend automatically reduces retained earnings by twice as much as the 15 percent stock dividend.
  21. ____ Return on equity (ROE) is found by dividing net income for a period by the average amount of retained earnings.
  22. ____ Basic earnings per share is required to be reported for all publicly-traded corporations.
  23. ____ Earnings per share is found by taking the net income for the year divided by the number of common shares outstanding at the end of the year.
  24. ____ The P/E ratio relates a company’s reported earnings per share to the market price of its common stock.
  25. ____ A company reports net income of $500,000 but pays cash dividends to preferred stock ($100,000) and common stock ($50,000). The company has 100,000 shares of common stock outstanding all year as well as 20,000 shares of preferred stock. Basic EPS is $3.50 per share.
  26. ____ Diluted EPS includes the potential negative impact of convertibles on the computation of earnings per share.

Multiple Choice

  1. Bob Wills, Susan Oglethorpe, and Billie Elkins form a business and decide to have it formally recognized as a corporation. Which of the following is the most likely reason for that decision?

    1. The limited liability that is available to the owners of a corporation.
    2. The advantages of mutual agency which are only available to the owners of a corporation.
    3. The double taxation faced by partnerships and sole proprietorships.
    4. The ease of forming a corporation.
  2. Which of the following rights is most typical for the owners of a corporation’s common stock?

    1. The right to vote for the members of the board of directors
    2. The right to an annual dividend
    3. The right to be involved in policy making decisions
    4. The right to decide on the issuance of a cash dividend
  3. Landon Corporation sold 16,000 shares of $0.50 par value common stock for $17 per share. Which of the following is the journal entry Landon should make?

    1. Figure 16.16

    2. Figure 16.17

    3. Figure 16.18

    4. Figure 16.19

  4. Jackson Company is authorized to issue 20,000 shares of $1 par value stock. On February 1, Year One, it issues 4,000 shares for $9 per share. On July 1, Year One, the company pays a $1 per share cash dividend. On December 1, Year One, the company buys back 1,000 shares of its own stock at $11 per share. Treasury stock is reported at its cost. On a December 31, Year One, balance sheet, what is reported as Capital in Excess of Par Value?

    1. $17,000
    2. $28,000
    3. $30,000
    4. $32,000
  5. Paul Mitchell purchased a licensing agreement for $40,000 from a well-known restaurant chain. Subsequently, Traylor Corporation agreed to issue 2,000 shares of its common stock to Mitchell in exchange for this licensing agreement, which now has a value of $30,000. At the time of the exchange, Traylor’s $2 par value stock was selling for $14 per share. For what amount should Traylor report the licensing agreement?

    1. $4,000
    2. $28,000
    3. $30,000
    4. $40,000
  6. Kramer Company is authorized by the state to issue 10,000 shares of 8 percent, $100 par value preferred stock. On January 1, Year One, Kramer issues 5,000 shares for $125 per share. On December 13, Year One, Kramer’s board of directors declares the annual dividend to owners on record as of January 3, Year Two. The dividend will be distributed January 18, Year Two. What liability should Kramer Company report on its December 31, Year One, balance sheet as a result of this dividend?

    1. Zero
    2. $40,000
    3. $50,000
    4. $80,000
  7. Barbara Waterman bought 10,000 shares of $2 par value common stock directly from the Towsend Corporation for $13 per share. Later she sold these shares to Benjamin Duke for $17 per share. Subsequently, he sold 2,000 of these shares back to Towsend for cash of $19 per share. The cost method is in use for the treasury stock. Just based on these transactions, what is the total amount reported by the company as its stockholders’ equity.

    1. $92,000
    2. $112,000
    3. $132,000
    4. $152,000
  8. The Kansas-Kentucky Corporation is started on January 1, Year One. The company issues 100,000 shares of its $1 par value common stock for $8 per share. Subsequently, the company reports net income of $40,000 each year and pays an annual cash dividend of $10,000. In Year Three, the company reacquires 10,000 of these shares for $15 each. The cost method is to be applied to the treasury stock. Several weeks later, the company reissues 1,000 shares of this stock for $17 per share. A few days later, another 2,000 shares are reissued for $12 per share. At the end of Year Three, what should the company report as its retained earnings?

    1. $84,000
    2. $86,000
    3. $88,000
    4. $90,000
  9. The Gewrty Corporation issues a 50 percent stock dividend. Which of the following is true about this event?

    1. The owners are happy because they own a larger percentage of the company.
    2. The owners are happy because the stock price will be lower, which might well create an increase in the demand for the company’s stock on the stock market.
    3. The owners are unhappy because the net assets have been reduced by the company’s action.
    4. The owners are unhappy because some owners benefit more than others from a stock dividend.
  10. The Anglewood Corporation has 200,000 shares of its $1 par value common stock outstanding. These shares currently have a market price of $15 each. The company decides to issue a 10 percent (20,000 shares) stock dividend. At the last moment, the board of directors decides to increase this stock dividend to 30 percent (60,000 shares). Which of the following is true about the impact of the change in this decision?

    1. Retained earnings will be $60,000 lower than it would have been.
    2. Retained earnings will be $90,000 lower than it would have been.
    3. Retained earnings will be $220,000 higher than it would have been.
    4. Retained earnings will be $240,000 higher than it would have been.
  11. The Kearsey Corporation issues 10,000 shares of its own common stock (with a $10 per share par value) for cash of $12 per share. Several months later, the company reacquires 1,000 shares of its own stock for $15 per share. This treasury stock is to be reported using the cost method. Which of the following statements is true?

    1. If these treasury shares are later reissued for $17,000, the $2,000 gain cannot be reported on the company’s income statement.
    2. The $15,000 cash outflow will be reported like a dividend as a reduction in retained earnings.
    3. The $15,000 cost of these treasury shares will be reported by the company as a noncurrent asset.
    4. When these shares are reacquired, the company’s contributed capital will increase by $15,000.
  12. Portor Corporation is authorized to issue 150,000 shares of its $0.25 par value common stock. It currently has 90,000 shares issued and outstanding. Portor plans to declare a stock dividend and is curious about the effect this will have on retained earnings. Portor’s stock has a current market value per share of $26. Portor is trying to decide between a 5 percent stock dividend and a 40 percent stock dividend. Which of the following shows the reduction caused by each on retained earnings?

      5% Stock Dividend 40% Stock Dividend
    a. $117,000 $936,000
    b. $117,000 $9,000
    c. $1,125 $9,000
    d. $1,125 $936,000
  13. Falls Church Corporation ended Year Four with revenues of $98,000 and expenses of $86,000. The company distributed a cash dividend of $8,000 during the year. No stock transactions occurred. On the year-end balance sheet, the stockholders’ equity accounts total $492,000. Which of the following is Falls Church’s return on equity (ROE) for the year?

    1. 2.45%
    2. 6.73%
    3. 9.18%
    4. 9.75%
  14. Fleming Corporation began and ended the current year with 50,000 outstanding shares of common stock. These shares were paid a $0.20 per share cash dividend. Net income for the year totaled $480,000. The company also had 10,000 shares of preferred stock outstanding throughout the year that paid dividends of $30,000. Which of the following figures is reported as Fleming’s basic earnings per share?

    1. $6.00 per share
    2. $9.00 per share
    3. $9.60 per share
    4. $10.60 per share
  15. The Houston Corporation started the year with 190,000 shares of common stock but issued 40,000 more shares on April 1 of the current year. The company also has 30,000 shares of preferred stock outstanding for the entire year. During the year, net income of $710,000 was reported. Cash dividends were paid during the year; $50,000 was distributed to the owners of the preferred stock and $30,000 to the owners of the common stock. What should be reported as basic earnings per share for this year (rounded)?

    1. $2.86
    2. $2.87
    3. $3.00
    4. $3.09
  16. The Zerton Corporation ends Year One with net income of $400,000 and 100,000 shares of common stock issued and outstanding. The company also has 30,000 shares of $50 par value preferred stock issued and outstanding. During the year, the company distributed a $1 per share cash dividend on its common stock and a $2 per share cash dividend on its preferred stock. Each share of preferred stock is convertible into two shares of common stock. What should the company report as its basic earnings per share (rounded)?

    1. $2.13
    2. $2.50
    3. $3.40
    4. $4.00
  17. Friar Inc. reported net income for Year Five of $1,870,000. It had 600,000 shares of common stock outstanding on January 1, Year Five, and repurchased 150,000 of those shares on September 1, Year Five, as treasury stock. The company has no preferred stock. At the end of Year Five, Friar’s stock was selling for $26 per share. Which of the following is Friar’s price-earnings ratio on that date?

    1. 6.25
    2. 7.00
    3. 7.65
    4. 8.33

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while waiting for an appointment with an academic advisor, your roommate asks you the following question: “My parents started their business originally as a partnership. However, after a year or two, they switched over and had the business incorporated. Since then, they complain every year about double taxation. What does that mean? And, if double taxation is so bad, why didn’t they just continue to function as a partnership? They seemed happier before they made this switch.” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has grown and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We are planning to build a new store in a town that is 50 miles from our headquarters. For us, this is a major expansion. We are going to need several million dollars in cash. We have looked at several options for raising this money. Our financial advisor has recommended that we issue preferred stock. I’m not totally sure what this means. And, I’m not sure why we wouldn’t just be better off to issue additional shares of the corporation’s common stock. Why is our financial advisor giving us this advice?” How would you respond?

Problems

  1. Cutlass Corporation is authorized by the state government to issue 40,000 shares of $1 par value common stock. On March 15, the company issues 1,000 shares for $6 cash per share. On April 19, the company issues another 800 shares for $7 per share. Record these transactions.
  2. McNair Corporation is authorized to issue 150,000 shares of 5 percent, $200 par value preferred stock. On January 22, McNair issues 32,000 shares of this preferred stock for $225 per share. The board of directors for McNair declares the annual preferred dividend on September 1, payable to owners on record as of September 17, with the money to be distributed on October 1.

    1. Record the issuance of the preferred stock.
    2. Record the declaration and payment of the dividend and provide the date for each entry.
  3. Several years ago, Douglas Company issued 33,000 shares of its $1 par value common stock for $18 per share. In the current year, Douglas’s board of directors approves a plan to buy back a portion of these common stock shares. Prepare journal entries for each of the following transactions and events.

    1. On Monday, Douglas buys back 2,500 shares for $35 per share.
    2. On Tuesday, Douglas reissues 1,000 shares of treasury stock for $37 per share.
    3. On Wednesday, Douglas reissues 500 shares of treasury stock for $34 per share.
    4. On Thursday, Douglas reissues 600 shares of treasury stock for $28.
    5. On Friday, the board of directors declares a cash dividend of $1.00 per share.
  4. The following are a number of transactions and events for the Nielsen Corporation. For each, prepare the necessary journal entry. If no entry is required, please indicate that.

    1. The state of Delaware approves the application for incorporation made by Nielsen and authorizes 100,000 shares of common stock with a $10 per share par value.
    2. Nielsen issues the first 1,000 shares of its common stock for $12 per share in cash.
    3. On the same day as (b), Nielsen issues another 500 shares of common stock for equipment that is valued at $6,200.
    4. Nielsen’s board of directors declares a $2 per share cash dividend.
    5. On the date of record for the previous dividend, Nielsen prepares a list of all owners.
    6. The date of payment arrives and Nielsen mails out all dividend distributions.
    7. A 10 percent stock dividend is declared and immediately issued after the market price of the common stock has risen to $19 per share.
    8. The company reacquires 300 shares of common stock for $16 per share in cash. Treasury stock is reported by means of the cost method.
    9. The company reissues 200 shares of its treasury stock for $17 per share in cash.
    10. The company reissues the remaining shares of treasury stock for $11 per share in cash.
    11. A 40 percent stock dividend is declared and immediately issued on a day when the fair value of the stock is $20 per share.
  5. At the beginning of Year One, a company issues 40,000 shares of $2 par value common stock for $23 per share in cash. The company also issues 10,000 shares of $40 par value preferred stock that pays an annual dividend of 10 percent. No dividend is paid in Year One but a total dividend of $100,000 is distributed in Year Two.

    1. If the preferred stock dividend is not cumulative, what is reported on the financial statements about the dividend at the end of Year One?
    2. If the preferred stock dividend is not cumulative, what amount of cash dividend does each share of common stock receive in Year Two?
    3. If the preferred stock dividend is cumulative, what is reported on the financial statements about the dividend at the end of Year One?
    4. If the preferred stock dividend is cumulative, what amount of cash dividend does each share of common stock receive in Year Two?
  6. The Rostinaja Company is incorporated at the beginning of Year One. For convenience, assume that the company earns a reported net income of $130,000 each year and pays an annual cash dividend of $50,000. The company is authorized to issue 200,000 shares of $3 par value common stock. At the start of Year One, the company issues 40,000 shares of this common stock for $8 per share. At the end of Year Two, the company buys back 5,000 shares of its own stock for $12 per share. The cost method is used to record these shares. At the start of Year Three, the company reissues 1,000 of these shares for $14 per share. At the start of Year Four, the company reissues the remainder of the treasury stock for $9 per share.

    1. Prepare the stockholders’ equity section of this company’s balance sheet as of December 31, Year One.
    2. Prepare the stockholders’ equity section of this company’s balance sheet as of December 31, Year Two.
    3. Prepare the stockholders’ equity section of this company’s balance sheet as of December 31, Year Three.
    4. Prepare the stockholders’ equity section of this company’s balance sheet as of December 31, Year Four.
  7. Grayson Corporation is authorized by the state to sell 2 million shares of its $1 par value common stock to the public. Before Year Seven, the company had issued 60,000 shares for cash of $12 per share. During Year Seven, Grayson issued another 14,000 shares at the market value of $24 per share.

    On January 1, Year Seven, Grayson reported retained earnings of $1,950,000. During that year, Grayson earned net income of $80,000 and paid cash dividends to common stockholders of $19,000. Also, during December of Year Seven, Grayson repurchased 11,000 shares of its own stock when the market price was $22 per share.

    1. Record the issuance of the common stock in Year Seven.
    2. Determine retained earnings as of the end of Year Seven.
    3. Record the purchase of the treasury stock.
    4. Prepare the stockholders’ equity section of the balance sheet as of December 31, Year Seven.
    5. Compute the company’s return on equity (ROE) for Year Seven.
  8. On December 28, Year One, the Pickins Corporation was formed. The articles of incorporation authorize 5 million shares of common stock carrying a $1 par value, and 1 million shares of $5 par value preferred stock. On January 1, Year Two, 2 million shares of common stock are issued for $15 per share. Also on January 1, 500,000 shares of preferred stock are issued at $30 per share.

    1. Prepare journal entries to record these transactions on January 1.
    2. On March 9, Year Two, the Pickins Corporation repurchases 100,000 common shares as treasury stock paying a price of $13 per share. During August of that year, all 100,000 treasury shares are reissued at $16 per share. Prepare journal entries to record these transactions.
    3. On November 3, Year Two, Pickins issues a 30 percent stock dividend on all outstanding shares of common stock when the market price is $50 per share. On December 1, Year Two, Pickens declares a $0.75 per share cash dividend on common stock and a $2.00 per share cash dividend on preferred stock. Payment is scheduled for December 20, Year Two, to shareholders of record on December 10, Year Two. Prepare journal entries to record the declaration and distribution of these stock and cash dividends.
  9. On March 1, St. George Company declares a stock dividend on its $1 par value stock. The company had 1,000 shares outstanding on that date with a market value of $13 per share.

    1. What reduction is recorded in retained earnings if a 10 percent stock dividend is issued?
    2. What reduction is recorded in retained earnings if a 30 percent stock dividend is issued?
  10. Rawlings Company has the following equity accounts at the beginning and end of Year Three:

      January 1, Year Three December 31, Year Three
    Preferred Stock, 6%, $100 par value $2,000,000 $2,000,000
    Common Stock, $1 Par Value $160,000 $200,000
    Capital in Excess of Par, Common $12,000,000 $16,000,000
    Retained Earnings $1,100,000 $1,800,000

    The common stock account increased because 40,000 shares of common stock were issued to the public on September 1, Year Three. Preferred stock was paid its dividend during the year. A cash dividend was also distributed on the common stock. Net income for the year was $1,200,000.

    1. How much cash was received when the common stock was issued during Year Three?
    2. What was the total cash dividend paid on the common stock shares during the year?
    3. What was the company’s basic earnings per share for Year Three?
  11. Information on Massaff Corporation’s stock accounts follows:

      December 31, Year 7 December 31, Year 8
    Outstanding shares of    
    Common stock 300,000 330,000
    Nonconvertible preferred stock 10,000 10,000

    The following additional information is available about this company:

    • On July 1, Year 8, Massaff issued 30,000 additional shares of common stock for cash.
    • Net income for the year ended December 31, Year 8, was $750,000.
    • During Year 8, Massaff paid dividends of $3.00 per share on its preferred stock. The company also paid a total cash dividend of $220,000 on its outstanding shares of common stock.

    Required:

    Compute Massaff’s basic earnings per common share for the year ended December 31, Year 8.

  12. Yesterday, the Neumann Corporation had 100,000 shares of common stock authorized, 60,000 shares issued, and 40,000 shares outstanding. The stock has a par value of $10 per share but was issued originally for $24 per share. The stock is currently selling on a stock exchange for $30 per share. Treasury stock was acquired for $25 per share. None of that stock has been reissued. It is recorded using the cost method.

    Today, a stock dividend was issued. After that dividend was distributed, the Neumann Corporation reported a total for its Capital in Excess of Par Value account of $960,000. How many shares were issued in the stock dividend?

  13. A company has 20,000 shares of common stock issued and outstanding. These shares have a par value of $10 per share but were issued for $17 per share. When the fair value of the shares hits $21 per share, the company declares and issues a 50 percent stock dividend. The company accidentally recorded these new shares as a small stock dividend (20 percent or less) when the issuance should have been reported as a large stock dividend. At the end of the year, the company reported total assets of $300,000, total retained earnings of $80,000, and total stockholders’ equity of $220,000.

    1. What was the proper amount of total assets that should have been reported?
    2. What was the proper amount of total retained earnings that should have been reported?
    3. What was the proper amount of total stockholders’ equity that should have been reported?
  14. In several past chapters, we have met Heather Miller, who started her own business, Sew Cool. The following are the financial statements for December.

    Figure 16.20 Sew Cool Financial Statements

    Figure 16.21

    Figure 16.22

    Based on the financial statements determine Sew Cool’s return on equity (ROE).

Comprehensive Problem

This problem will carry through several chapters, building in difficulty. It allows students to continually practice skills and knowledge learned in previous chapters.

In Chapter 15 “In a Set of Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities?”, financial statements for March were prepared for Webworks. They are included here as a starting point for the required recording for April.

Here are Webworks financial statements as of March 31.

Figure 16.23 Webworks Financial Statements

Figure 16.24

Figure 16.25

The following events occur during April:

  1. Webworks starts and completes ten more sites and bills clients for $7,000.
  2. Leon invites Nancy Po (an employee) to invest money in the business. She contributes $2,000 and becomes an equal owner with Leon.
  3. Webworks purchases supplies worth $125 on account.
  4. At the beginning of March, Webworks had fourteen keyboards costing $120 each and twenty-eight flash drives costing $23 each. Webworks uses periodic FIFO to cost its inventory.
  5. Webworks purchases ninety-five keyboards for $121 each and ninety flash drives for $25 each. All purchases are on account.
  6. Webworks sells eighty-seven keyboards for $13,050 and ninety of the flash drives for $2,850 cash.
  7. Webworks collects $6,400 in accounts receivable.
  8. Webworks pays its $500 rent.
  9. Webworks pays off $14,000 of its accounts payable.
  10. Webworks sells all of its shares of RST stock for $20 per share.
  11. Webworks pays Juan Marcon (another employee) $700 for his work during the first three weeks of April.
  12. Webworks writes off an account receivable from December in the amount of $150 because collection appears unlikely.
  13. Webworks pays off its salaries payable from March.
  14. Webworks pays Leon Jackson and Nancy Po a salary of $3,500 each.
  15. Webworks completes the design for the photographer for which it was paid in February. The $300 of unearned revenue has now been earned.
  16. Webworks pays Leon Jackson and Nancy Po a dividend of $250 each.
  17. Webworks pays taxes of $372 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for April.
    4. Prepare adjusting entries at the end of February for the following and post them to your T-accounts.
  18. Webworks owes Juan Marcon $100 for his work during the last week of April.
  19. Webworks receives an electric bill for $440. Webworks will pay the bill in May.
  20. Webworks determines that it has $65 worth of supplies remaining at the end of April.
  21. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  22. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method.
  23. The license agreement should be amortized over its one-year life.
  24. QRS Company is selling for $14 per share on April 30.
  25. Interest should be accrued for April.
  26. Record cost of goods sold.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements for April.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in Advanced Micro Devices Inc. The partner is aware that technology companies like AMD often issue a lot of stock options and other items that can be converted into shares of common stock. The partner is curious as to the potential impact such conversions might have on the company and the price of its stock. The partner asks you to look at the 2010 financial statements for AMD by following this path:

  • Go to http://www.amd.com.
  • At the top of this screen, click on “About AMD.”
  • In the center of the next screen, click on “Investor Relations.”
  • On the left side of the next screen, click on “Annual Report & Proxy.”
  • On the next screen, click on “2010 Annual Report” to download.
  • Scroll to page 73 and find the company’s statement of operations (income statement) for the year ended December 25, 2010. At the bottom of that statement, determine the basic earnings per share reported by AMD as well as the diluted earnings per share. In addition, note the number of common stock shares used in the computation of basic earnings per share and the number of common stock shares used in the computation of diluted earnings per share.
  • Scroll down to page 81 and read the last paragraph on that page which is part of “Note 2: Summary of Significant Accounting Policies.” This paragraph mentions that AMD has three types of instruments outstanding that can be converted into common stock.
  1. For the year ended December 25, 2010, what is the amount reported for basic earnings per share and for diluted earnings per share? What is the amount of the difference in those two figures?
  2. Assume that the common stock of AMD was selling on the New York Stock Exchange on December 25, 2010, at $8.05. What was the P/E Ratio?
  3. What were the three types of convertible items that AMD had outstanding at this time?
  4. How many shares of common stock were used in computing basic earnings per share and how many shares of common stock were used in computing diluted earnings per share? How many shares were added to arrive at diluted earnings per share as a result of the possible conversion of the items listed in the answer to (c)?

Chapter 15: In a Set of Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 15 “In a Set of Financial Statements, What Information Is Conveyed about Other Noncurrent Liabilities?”.

15.1 Accounting for Leases

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Understand the theoretical difference between an operating lease and a capital lease.
  2. Recognize that a lessee will be required to account for a lease as either an operating lease or a capital lease based on the specific terms of the contract.
  3. Understand the concept of off-balance sheet financing.
  4. Explain the term “substance over form” and how it applies to the financial reporting of a capital lease.

Reporting a Liability for Leased Property

Question: Notes and bonds payable serve as the predominant source of long-term financing in the United States. Virtually all companies raise significant sums of money by incurring debts of this type. However, a quick perusal of the balance sheets of most well-known companies finds a broad array of other noncurrent liabilities, some of staggering size.

  • Sears Holdings Corporation disclosed long-term capital lease obligations of $597 million as of January 29, 2011.
  • Southwest Airlines Co. reported deferred income tax liabilities of approximately $2.5 billion on December 31, 2010.
  • Alcoa Inc. at December 31, 2010, lists $2.6 billion in liabilities (slightly under 12 percent of the company’s total) labeled as accrued postretirement benefitsPromises such as pension payments, health care insurance coverage, and life insurance benefits made by employers to eligible employees to be received after the individuals reach a specified retirement age. (other than pensions).

These noncurrent liabilities represent large amounts of debts that are different from traditional notes and bonds. Some understanding of these balances is necessary to comprehend the information being conveyed in a set of financial statements. The reporting of liabilities such as those above is explored in depth in upper-level financial accounting courses. However, a basic level of knowledge is essential for every potential decision maker, not just those individuals who chose to major in accounting in college.

Lease liabilities will be explored first in this chapter. To illustrate, assume that the Abilene Company needs an airplane to use in its daily operations. Rather than buy this asset, Abilene leases one from a business that owns a variety of aircraft. The lease is for seven years at an annual cost of $100,000. A number of reasons might exist for choosing to lease rather than buy. Perhaps Abilene is able to negotiate especially good terms for the airplane because of the company’s willingness to commit to such a long period of time.

On the day that the lease is signed, should Abilene report a liability and, if so, is the amount just the first $100,000 installment, the $700,000 total of all payments, or some other figure? When a company leases an asset, how is the related liability reported?

 

Answer: The liability balance to be reported by the Abilene Company cannot be determined based purely on the information that is provided. When a lesseeA party that pays cash for the use of an asset in a lease contract. (the party that will make use of the asset) signs a lease agreement, the transaction is recorded in one of two ways based on the terms of the contract.

Possibility One—An Operating LeaseA rental agreement where the benefits and risks of ownership are not conveyed from the lessor to the lessee.. Abilene might have obtained the use of this airplane through an operating lease, a rental arrangement. If so, the liability recognized when the contract is signed is $100,000, only the amount due immediately. Upon payment, the reported debt is reduced to zero despite the requirement that six more installments have to be paid. In financial accounting, the future payments on an operating lease are viewed as a commitment rather than a liability. Thus, information about those payments is disclosed in the notes to the financial statements but not formally reported.

Possibility Two—A Capital LeaseA rental agreement where the benefits and risks of ownership are conveyed from the lessor to the lessee so that both the asset and liability are reported initially by the lessee at the present value of the cash payments; for accounting purposes, it exists when one of four established criteria are met.. This transaction could also have met specific criteria for classification as a capital lease. That type of lease is viewed as the equivalent of Abilene buying the airplane. The initial liability recognized by Abilene is the present value of the $700,000, the entire amount of cash to be paid over these seven years. The present value is determined by the mathematical removal of a reasonable rate of interest.

Test Yourself

Question:

A lessee signs a lease agreement so that a piece of property can be used for the specified period of time. From an accounting perspective, what are the two types of leases?

  1. Fixed leases and variable leases
  2. Operating leases and capital leases
  3. Income leases and expenditure-based leases
  4. Noncontractual leases and contractual leases

Answer:

The correct answer is choice b: Operating leases and capital leases.

Explanation:

For the lessee, all leases are classified for financial reporting purposes as either a rental (an operating lease) or the equivalent of a purchase (a capital lease).

Does a Lessee Prefer to Report an Operating or Capital Lease?

Question: The previous answer raises a number of immediate questions about lease accounting. Probably the first of these relates to the practical goal of officials who want to produce financial statements that make their company look as financially healthy as possible. A lease agreement can be reported as (a) an operating lease with only the initial payment recorded as a liability or (b) a capital lease where the present value of all payments (a much larger number) is shown as the liability.

Officials for the lessee must surely prefer to classify all leases as operating leases to reduce the reported debt total. In financial accounting, does a lessee not have a bias to report operating leases rather than capital leases?

 

Answer: The answer to this question is obviously “Yes.” If an option exists between reporting a larger liability (capital lease) or a smaller one (operating lease), officials for the lessee are inclined to take whatever measures necessary to classify each contract as an operating lease. This is not a choice such as applying FIFO or LIFO. The reporting classification is based on the nature of the agreement.

Thus, Abilene Company will likely attempt to structure the contract for this airplane to meet any designated criteria for an operating lease. Financial accounting is supposed to report events and not influence them. However, at times, authoritative reporting standards impact the method by which companies design the transactions in which they engage.

If the previous example is judged to be an operating lease, Abilene only reports an initial liability of $100,000 although legally bound by the agreement to pay a much larger amount. The term off-balance sheet financingDescription used for an obligation where an amount of money must be paid that is larger than the figure reported on the balance sheet; for a lessee, an operating lease provides an example of off-balance sheet financing. is commonly used when a company is obligated for more money than the reported debt. Operating leases are one of the primary examples of “off-balance sheet financing.”

As mentioned at the start of this chapter, Sears Holdings Corporation reports noncurrent liabilities of about $597 million on January 29, 2011, in connection with capital leases. However, that obligation seems small in comparison to the amount to be paid by the company on its operating leases. As the notes to those financial statements explain, Sears has numerous operating leases (for the use of stores, office facilities, warehouses, computers and transportation equipment) that will require payment of over $5.3 billion in the next few years. Most of the debt for this additional $5.3 billion is “off the balance sheet.” In other words, the obligation is not included in the liability section of the company’s balance sheet. For an operating lease, the reported liability balance does not reflect the total obligation, just the current amount that is due.

Test Yourself

Question:

A lessee is negotiating a new lease for a large piece of property. Which of the following is most likely to be true?

  1. The lessee will try to structure this contract as an operating lease to take advantage of off-balance sheet financing.
  2. The lessee will not care whether the contract is viewed as an operating lease or a capital lease.
  3. The lessee will try to structure this contract as a capital lease to avoid the implications of off-balance sheet financing.
  4. The lessee will structure the contract in whatever way is most convenient for the lessor (the actual owner of the property).

Answer:

The correct answer is choice a: The lessee will try to structure this contract as an operating lease to take advantage of off-balance sheet financing.

Explanation:

The liability balance reported for an operating lease is only the amount currently due. For most leases, that is a relatively small amount. A lessee will typically prefer to create this type of lease so that the reported liability total is lower. The remainder of the obligation will not be recognized until it comes due. The ability to use accounting rules to omit some amount of debt is commonly known as off-balance sheet financing.

Differentiating an Operating Lease from a Capital Lease

Question: For a lessee, a radical difference in reporting exists between operating leases and capital leases. Company officials prefer to report operating leases so that the amount of liabilities appearing on the balance sheet is lower. What is the distinction between an operating lease and a capital lease?

 

Answer: In form, all lease agreements are rental arrangements. One party (the lessor) owns legal title to property while the other (the lessee) rents the use of that property for a specified period of time. However, in substance, a lease agreement may go beyond a pure rental agreement. Financial accounting has long held that a fairly presented portrait of an entity’s financial operations and economic health is only achieved by looking past the form of a transaction to report the actual substance of what is taking place. “Substance over form” is a mantra often heard in financial accounting.

Over thirty years ago, U.S. GAAP was created (by FASB) to provide authoritative guidance for the financial reporting of leases. An official pronouncement released at that time states that “a lease that transfers substantially all of the benefits and risks incident to the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee.” In simple terms, this standard means that a lessee can obtain such a significant stake in leased property that the transaction more resembles a purchase than it does a rental. If the transaction looks like a purchase, the accounting should be that of a purchase.

When the transaction is more like a purchase, it is recorded as a capital lease. When the transaction is more like a rental, it is recorded as an operating lease.

  • Capital lease. The lessee gains substantially all the benefits and risks of ownership. Although legal form is still that of a lease arrangement, the transaction is reported as a purchase at the present value of the future cash flows.
  • Operating lease. The lessee does not obtain substantially all the benefits and risks of ownership. The transaction is reported as a rental arrangement.

Test Yourself

Question:

A lessee signs a contract with the word “LEASE” typed across the top. Which of the following statements is true?

  1. Rental expense will be recognized over the life of this contract.
  2. If this contract is accounted for as a capital lease, that is an example of reporting substance over form.
  3. If this contract is accounted for as an operating lease, that is an example of reporting form over substance.
  4. Because a formal legal document has been created, this lease must be reported as a capital lease.

Answer:

The correct answer is choice b: If this contract is accounted for as a capital lease, that is an example of reporting substance over form.

Explanation:

Although this contract is in the form of a rental arrangement, it must be accounted for as a capital lease if it has the substance of a purchase. Accountants always want to record the substance of a transaction rather than its mere form. Without knowing the information provided in the contract, the accountant cannot determine whether rent expense is appropriate here (an operating lease) or if the arrangement is the equivalent of a purchase (a capital lease).

Criteria for a Capital Lease

Question: A capital lease is accounted for as a purchase because it so closely resembles the acquisition of the asset. An operating lease is more like a rent. The lessee normally prefers to report all such transactions as operating leases to reduce the amount of debt shown on its balance sheet. How does an accountant determine whether a contract qualifies as a capital lease or an operating lease?

 

Answer: In establishing reporting guidelines in this area, FASB created four specific criteria to serve as the line of demarcation between the two types of leases. Such rules set a standard that all companies must follow. If any one of these criteria is met, the lease is automatically recorded by the lessee as a capital lease. In that case, both the asset and liability are reported as if an actual purchase took place.

Not surprisingly, accountants and other company officials study these four criteria carefully. They hope to determine how the rules can be avoided so that most of their new contracts are viewed as operating leases. Interestingly, in recent years, official groups here and abroad have been examining these rules to decide whether U.S. GAAP and IFRS will be revised so that virtually all leases are reported as capital leases. At this time, the final outcome of those deliberations remains uncertain. However, a serious limitation on the use of the operating lease category seems likely in the next few years.

Criteria to Qualify as a Capital Lease (only one must be met):

  1. If the lease contract specifies that title to the property will be conveyed to the lessee by the end of the lease term, it is a capital lease. If legal ownership is to be transferred from lessorA party that receives cash for granting the use of owned property to a lessee through a lease contract. to lessee, the entire series of payments is simply a method devised to purchase the asset. From the beginning, the property was being acquired.
  2. If the contract allows the lessee to buy the property at a specified time at an amount sufficiently below expected fair value (so that a purchase is reasonably assured), it is a capital lease. The availability of this bargain purchase option indicates, once again, that the true intention of the contract is the conveyance of ownership. The transaction is the equivalent of a purchase if the option price is so low that purchase by the lessee can be anticipated.
  3. If the lease contract is for a term that is equal to 75 percent or more of the estimated life of the property, it is a capital lease. This criterion is different from the first two where the transaction was just a disguised purchased. Here, the lessee will never gain ownership. However, the lease is for such an extensive portion of the asset’s life that the lessee obtains a vast majority of its utility. Although the 75 percent standard is an arbitrary benchmark, no doubt can exist that the lessee will be the primary beneficiary of the property.
  4. The fourth criterion is too complicated to cover in an introductory textbook. The general idea is that the lessee is paying approximately the same amount as would have been charged to buy the asset. Paying the equivalent of the purchase price (or close to it) indicates that no real difference exists between the nature of the lease transaction and an acquisition.

Test Yourself

Question:

A lessee signs a three-year lease for $79,000 per year to gain use of a machine. The machine has an expected useful life of five years. At the end of this three-year period, the machine is expected to be worth $60,000. The lessee has the right to buy it at that time for $50,000. The required payments are not the equivalent of the acquisition value of this asset. Which of the following is true for the lessee?

  1. The lease is a capital lease.
  2. The lease is an operating lease.
  3. The lease might be a capital lease but not enough information is available.
  4. The lease will be an operating lease if one of the four criteria is met.

Answer:

The correct answer is choice c: The lease might be a capital lease but not enough information is available.

Explanation:

If one of the four criteria established by FASB is met, this lease is reported as a capital lease. One of the criteria is still in question. Is a $50,000 purchase option viewed as a bargain if the expected fair value is $60,000? Is the $10,000 discount sufficient so that purchase is reasonably assured? Although the rules are clear, those judgments can be extremely difficult to make in practice. Not enough information is provided here to determine whether this purchase option is a bargain.

Key Takeaway

A lessee accounts for a lease contract as either an operating lease or a capital lease depending on the specific terms of the agreement. Officials working for the lessee will likely prefer the contract to qualify as an operating lease because a smaller liability is reported. Thus, the reporting of an operating lease is a common example of off-balance sheet financing because a significant portion of the contractual payments are not included as liabilities on the balance sheet. In contrast, for a capital lease, the present value of all future cash flows must be reported as a liability. To differentiate operating leases from capital leases, four criteria have been established within U.S. GAAP. If any one of these criteria is met, the lessee accounts for the transaction as a capital lease. Although still a lease in legal form, the contract is viewed as a purchase in substance and reported in that manner.

15.2 Operating Leases versus Capital Leases

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Account for an operating lease, realizing that the only liability to be reported is the amount that is currently due.
  2. Understand that the only asset reported in connection with an operating lease is prepaid rent if payments are made in advance.
  3. Record the initial entry for a capital lease with both the asset and the liability calculated at the present value of the future cash flows.
  4. Explain the interest rate to be used by the lessee in determining the present value of a capital lease and the amount of interest expense to be recognized each period.
  5. Determine and recognize the depreciation of an asset recorded as the result of a capital lease.

The Financial Reporting of an Operating Lease

Question: The Abilene Company has agreed to pay $100,000 per year for seven years to lease an airplane. Assume that legal title will not be received by Abilene and no purchase option is mentioned in the contract. Assume also that the life of the airplane is judged to be ten years and the payments do not approximate the fair value of the item.

The contract is signed on December 31, Year One, with the first annual payment made immediately. Based on the description of the agreement, none of the four criteria for a capital lease have been met. Thus, Abilene has an operating lease. What financial accounting is appropriate for an operating lease?

 

Answer: None of the four criteria for a capital lease is met in this transaction:

  1. Legal ownership is not conveyed to the lessee.
  2. No bargain purchase option is included in the contract.
  3. The life of the lease is less than 75 percent of the life of asset (seven years out of ten years or 70 percent).
  4. Payments do not approximate the acquisition value of the asset.

Thus, Abilene is just renting the airplane and agrees on an operating lease. The first annual payment was made immediately to cover the subsequent year.

Figure 15.1 December 31, Year One—Payment of First Installment of Operating Lease

Because the first payment has been made, no liability is reported on Abilene’s balance sheet although the contract specifies that an additional $600,000 in payments will be required over the subsequent six years. In addition, the airplane itself is not shown as an asset by the lessee. The operating lease is viewed as the equivalent of a rent and not a purchase.

During Year Two, as time passes, the future value provided by the first prepayment gradually becomes a past value. The asset balance is reclassified as an expense. At the end of that period, the second payment will also be made.

Figure 15.2 December 31, Year Two—Adjustment to Record Rent Expense for Year Two

Figure 15.3 December 31, Year Two—Payment of Second Installment of Operating Lease

Initial Recording of a Capital Lease

Question: One slight change can move this contract from an operating lease to a capital lease. Assume all the information remains the same in the previous example except that the airplane has an expected life of only nine years rather than ten. With that minor alteration, the life of the lease is 77.8 percent of the life of the asset (seven years out of nine years). The contract is now 75 percent or more of the life of the asset. Because one of the criteria is now met, this contract must be viewed as a capital lease. The change in that one estimation creates a major impact on the reporting process. How is a capital lease reported initially by the lessee?

 

Answer: As a capital lease, the transaction is reported in the same manner as a purchase. Abilene has agreed to pay $100,000 per year for seven years, but no part of this amount is specifically identified as interest. According to U.S. GAAP, if a reasonable rate of interest is not explicitly paid each period, a present value computation is required to split the contractual payments between principal (the amount paid for the airplane) and interest (the amount paid to extend payment over this seven-year period). This accounting is not only appropriate for an actual purchase when payments are made over time but also for a capital lease.

Before the lessee computes the present value of the future cash flows, one issue must be resolved. A determination is needed of the appropriate rate of interest to be applied. In the previous discussion of bonds, a negotiated rate was established between the investor and the issuing company. No such bargained rate exists in connection with a lease. According to U.S. GAAP, the lessee should use its own incremental borrowing rate. That is the interest rate the lessee would be forced to pay to borrow this same amount of money from a bank or other lending institution.As explained in upper-level accounting textbooks, under certain circumstances, the lessee might use the implicit interest rate built into the lease contract by the lessor. Assume here that the incremental borrowing rate for Abilene is 10 percent per year. If the company had signed a loan to buy this airplane instead of lease it, the assumption is that the lender would have demanded an annual interest rate of 10 percent.

Abilene will pay $100,000 annually over these seven years. Because the first payment is made immediately, these payments form an annuity due. As always, the present value calculation computes the interest at the appropriate rate and then removes it to leave the principal: the amount of the debt incurred to obtain the airplane. Once again, present value can be found by table (in the following link or included at the end of this book), by formula, or by Excel spreadsheet.On an Excel spreadsheet, the present value of a $1 per period annuity due for seven periods at an assumed annual interest rate of 10 percent is computed by typing the following data into a cell: =PV(.10,7,1,,1).

Present value of an annuity due of $1 per year for seven years at a 10 percent annual interest rate is $5.35526. The present value of seven payments of $100,000 is $535,526.

present value = $100,000 × 5.35526 present value = $535,526

After the present value has been determined, the recording of the capital lease proceeds very much like a purchase made by signing a long-term liability.

Figure 15.4 December 31, Year One—Capital Lease Recorded at Present Value

Figure 15.5 December 31, Year One—Initial Payment on Capital Lease

A comparison at this point between the reporting of an operating lease and a capital lease is striking. The differences are not inconsequential. For the lessee, good reasons exist for seeking an operating lease rather than a capital lease.

Figure 15.6 Comparison of Initially Reported Amounts for an Operating Lease and for a Capital Lease

Test Yourself

Question:

A company signs a lease on January 1, Year One, to lease a machine for eight years. Payments are $10,000 per year with the first payment made immediately. The company has an incremental borrowing rate of 6 percent. This lease qualifies as a capital lease. The present value of an ordinary annuity of $1 for eight periods at an annual interest rate of 6 percent is $6.20979. The present value of an annuity due of $1 for eight periods at an annual interest rate of 6 percent is $6.58238. If financial statements are produced after this lease has been signed and settled, which of the following balances will be reported (rounded)?

  1. Leased asset of $62,098 and lease liability of $52,098
  2. Leased asset of $52,098 and lease liability of $62,098
  3. Leased asset of $65,824 and lease liability of $55,824
  4. Leased asset of $55,824 and lease liability of $65,824

Answer:

The correct answer is choice c: Leased asset of $65,824 and lease liability of $55,824.

Explanation:

Because the first payment is made immediately, this contract is classified as an annuity due. As a capital lease, both the asset and the liability are initially reported at the present value of these cash flows at the lessee’s incremental borrowing rate or $65,824 ($10,000 × $6.5824). However, the first $10,000 payment is also made at that time so the liability balance is reduced by that amount.

Accounting for a Capital Lease over Time

Question: In a capital lease, property is not bought but is accounted for as if it had been purchased. When the contract is signed in the previous example, Abilene records both the leased airplane and the liability at the present value of the required cash payments. What reporting takes place subsequent to the initial recording of a capital lease transaction?

 

Answer: As with any purchase of an asset having a finite life where payments extend into the future, the cost of the asset is depreciated, and interest is recognized in connection with the liability. This process remains the same whether the asset is bought or obtained by capital lease.

Depreciation. The airplane will be used by Abilene for the seven-year life of the lease. The recorded cost of the asset is depreciated over this period to match the expense recognition with the revenue that the airplane helps generate. Assuming the straight-line method is applied, annual depreciation is $76,504 (rounded) or $535,526/seven years.

Interest. The principal of the lease liability during Year Two is $435,526. That balance is the initial $535,526 present value less the first payment of $100,000. The annual interest rate used in determining present value was 10 percent so interest expense of $43,553 (rounded) is recognized for this period of time—the liability principal of $435,526 times this 10 percent annual rate. As in the chapter on bonds and notes, the effective rate method is applied here.

Figure 15.7 December 31, Year Two—Depreciation of Airplane Obtained in Capital Lease

Figure 15.8 December 31, Year Two—Interest on Lease Liability from Capital Lease

Figure 15.9 December 31, Year Two—Second Payment on Capital Lease

Test Yourself

Question:

A company leases a truck for its operations. The accountant is attempting to determine if this lease is a capital lease or an operating lease. Which of the following statements is true?

  1. The reported liability balance is likely to be higher in an operating lease.
  2. A prepaid rental account is likely to be reported in a capital lease.
  3. The leased asset will appear in the financial statements if this is an operating lease.
  4. Both depreciation expense and interest expense are recognized for a capital lease.

Answer:

The correct answer is choice d: Both depreciation expense and interest expense are recognized for a capital lease.

Explanation:

In an operating lease, a prepaid rent account is established by the cash payments with that amount then reclassified to rent expense as time passes. Little or no liability is reported. In a capital lease, both the asset and the liability are reported at the present value of the future cash payments. The cost attributed to the asset is depreciated while interest expense must be recognized on the liability balance each period.

Talking with an Independent Auditor about International Financial Reporting Standards

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: In U.S. GAAP, if a lease arrangement meets any one of four criteria, the transaction is reported as a capital lease. Companies often design transactions to either avoid or meet these criteria based on the desired method of accounting. Do IFRS requirements utilize the same set of criteria to determine whether a capital lease or an operating lease has been created?

Rob Vallejo: This is difficult to answer based on the current status of the FASB and IASB’s joint project on “Leases” that began with a discussion paper in 2009. After receiving a large number of comments on a draft version of a new standard, the FASB and IASB are currently making revisions and will release a new draft version in the first half of 2012. Regardless of the outcome, after the new standard is issued (effective date could be as early as 2014), the distinction between operating and capital leases will be eliminated, as all leases will be treated as finance leases and included on the balance sheet at inception. For organizations that have structured leases to meet the definition of an operating lease, the new standard will have a significant impact. Officials should already be considering the implications to their financial statements and ongoing financial reporting. To check the latest status of the FASB and IASB’s joint project on leases, check the FASB’s web-site, http://www.FASB.org. Currently, a leasing arrangement may well be classified differently under IFRS than under U.S. GAAP. This is an example of where existing U.S. GAAP has rules and IFRS has principles. Under today’s U.S. GAAP, guidance is very specific based on the four rigid criteria established by FASB. However, under IFRS, the guidance focuses on the substance of the transaction and there are no quantitative breakpoints or bright lines to apply. For example, there is no definitive rule such as the “75 percent of the asset’s life” criterion found in U.S. GAAP. IFRS simply asks the question: have all the risks and rewards of ownership been substantially transferred?

Key Takeaway

Operating leases record payment amounts as they come due and are paid. Therefore, the only reported asset is a prepaid rent, and the liability is the current amount due. For a capital lease, the present value of all future cash payments is determined using the incremental borrowing rate of the lessee. The resulting amount is recorded as both the leased asset and the lease liability. The asset is then depreciated over the time that the lessee will make use of it. Interest expense is recorded (along with periodic payments) in connection with the liability as time passes using the effective rate method.

15.3 Recognition of Deferred Income Taxes

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Understand that the recognition of revenues and expenses under U.S. GAAP differs at many critical points from the taxation rules established by the Internal Revenue Code.
  2. Explain the desire by corporate officials to defer the payment of income taxes.
  3. Determine the timing for the reporting of a deferred income tax liability and explain the connection of this process to the matching principle.
  4. Calculate taxable income as well as the related deferred income tax liability when the installment sales method is used.

The Reporting of Deferred Tax Liabilities

Question: At the beginning of this chapter, mention was made that Southwest Airlines reported deferred income taxes at the end of 2010 as a noncurrent liability of $2.5 billion. Such an account balance is not unusual. The Dow Chemical Company listed a similar debt of almost $1.3 billion on its December 31, 2010, balance sheet while Marathon Oil Corporation showed approximately $3.6 billion. What information is conveyed by these huge account balances? How is a deferred income tax liability created?

 

Answer: The reporting of deferred income tax liabilitiesA balance sheet account indicating that the current payment of an income tax amount has been delayed until a future date; companies often seek to create this deferral so that tax dollars can be used in the interim to increase net income. is, indeed, quite prevalent. One recent survey found that approximately 70 percent of businesses included a deferred tax balance within their noncurrent liabilities.Matthew Calderisi, senior editor, Accounting Trends & Techniques, 63rd edition (New York: American Institute of Certified Public Accountants, 2009), 279. Decision makers need to have a basic understanding of any account that is so commonly encountered in a set of financial statements.

In the earlier discussion of LIFO, the disparity between financial accounting principles and income tax rules was described. In the United States, financial information is presented based on the requirements of U.S. GAAP (created by FASB) whereas income tax reporting is determined according to the Internal Revenue Code (written by Congress). At many places, these two sets of guidelines converge. If a grocery store sells a can of tuna fish for $6 in cash, the revenue is $6 on both the reported financial statements and the income tax return. However, at a number of critical junctures, the recognized amounts can be quite different.

Where legal, companies frequently exploit these differences for their own benefit by delaying tax payments. The deferral of income taxes is usually considered a wise business strategy because the organization is able to use its cash for a longer period of time and, hence, generate additional revenues. When paid, the money is gone, but until then, it can be used to raise net income. For example, if an entity earns a 10 percent return on assets and manages to defer a tax payment of $700 million for one year, the increased profit is $70 million ($700 million × 10 percent).

Businesses commonly attempt to reduce their current taxable income by moving reported gains and revenue into the future. That is one prevalent method for deferring tax payments. SouthwestDow Chemical, and Marathon likely used this approach to create a portion of the deferred tax liabilities they are reporting. Revenue or a gain might be recognized this year for financial reporting purposes although deferred until an upcoming time period for tax purposes. Consequently, the payment of tax on this income is pushed into that future year. As long as the tax laws are obeyed, such deferral is legal.

Taxable income is reduced in the current period (revenue is moved out) but increased at a later time (the revenue is moved back into taxable income). Because a larger tax will have to be paid in the subsequent period, a deferred income tax liability is created. To illustrate, assume that a business reports revenue of $10,000 on its Year One income statement. Because of tax rules and regulations, assume that this amount will not be subject to income taxation until Year Six. The $10,000 is referred to as a temporary tax differenceA revenue or expense reported for both financial accounting and income tax purposes but in two different time periods; leads to the recognition of deferred income taxes.. It is reported for both financial accounting and tax purposes but in two different time periods.

If the effective tax rate for this business is 40 percent, it reports a $4,000 ($10,000 × 40 percent) deferred income tax liability on its December 31, Year One, balance sheet. The revenue was earned in Year One, so the related expense and liability are also recorded in Year One. This amount will be paid to the government but not until Year Six when the revenue becomes taxable. The revenue is recognized now according to U.S. GAAP but in a later year for income tax purposes. Although, net income is higher in the current year than taxable income, taxable income will be higher in the future by $10,000. Most important, payment of the $4,000 income tax is delayed until Year Six.

Simply put, a deferred income tax liabilityMany companies also report deferred income tax assets that arise because of other differences in U.S. GAAP and the Internal Revenue Code. For example, Southwest Airlines included a deferred income tax asset of $214 million on its December 31, 2010, balance sheet. Accounting for such assets is especially complex and will not be covered in this textbook. Some portion of this asset balance, although certainly not all, is likely to be the equivalent of a prepaid income tax where Southwest was required to make payments by the tax laws in advance of recognition according to U.S. GAAP. is created when an event occurs now that will lead to a higher amount of income tax payment in the future.

Test Yourself

Question:

A company earns $60,000 late in Year One. The tax rate is 25 percent so the tax payment on this income will be $15,000. Because of a specific rule in the Internal Revenue Code, this $60,000 is not taxable until Year Two. Thus, the $15,000 will be paid on March 15, Year Three when the company files its Year Two income tax return. Which of the following statements is true?

  1. The liability is first recognized in Year One even though payment is not made until Year Three.
  2. The liability is first recognized in Year Two even though payment is not made until Year Three.
  3. The liability is not recognized until Year Three when the tax return is filed.
  4. There is not enough information presented here to determine when the liability should first be recognized.

Answer:

The correct answer is choice a: The liability is first recognized in Year One even though payment is not made until Year Three.

Explanation:

The income is recognized in Year One so the related income tax expense should be recognized in that same period to conform to the matching principle. Because recognition of the income has been delayed for tax purposes, a deferred income tax liability is also reported in Year One to disclose the future payment. The income was earned in Year One according to U.S. GAAP so the related liability must be reported then as well.

The Installment Sales Method and Deferred Income Taxes

Question: Assume that the Hill Company buys an asset (land, for example) for $150,000. Later, this asset is sold for $250,000 during Year One. The earning process is substantially complete at that point. Hill reports a gain on its Year One income statement of $100,000 ($250,000 less $150,000). Because of the terms of the sales contract, this money will not be collected from the buyer until Year Five. The buyer is financially strong and should be able to pay at the required times. Hill’s effective tax rate for this transaction is 30 percent.

Officials for Hill are pleased to recognize the $100,000 gain on this sale in Year One because it makes the company looks better. However, they prefer to wait as long as possible to pay the income tax especially since no cash has yet been collected. How can the recognition of income for tax purposes be delayed, thereby creating the need to report a deferred income tax liability?

 

Answer: According to U.S. GAAP, this $100,000 gain is recognized on Hill Company’s income statement in Year One based on accrual accounting. The earning process is substantially complete and the amount to be collected can be reasonably estimated. However, if certain conditions are met, income tax laws permit taxpayers to report such gains using the installment sales method.The installment sales method can also be used for financial reporting purposes but only under very limited circumstances. In simple terms, the installment sales method allows a seller to delay reporting a gain for tax purposes until cash is collected. In this illustration, no cash is received in Year One, so no taxable income is reported. The tax will be paid in Year Five when Hill collects the cash. Thus, as shown in Figure 15.10 “Year One—Comparison of Financial Reporting and Tax Reporting”, the income is reported now on the financial statements but not until Year Five for tax purposes.

Figure 15.10 Year One—Comparison of Financial Reporting and Tax Reporting

The eventual tax to be paid on the gain will be $30,000 ($100,000 × 30 percent). How is this $30,000 reported in Year One if payment to the government is not required until Year Five?

  • First, because of the matching principle, the income tax expense of $30,000 must be recorded in Year One. The $100,000 gain is reported on the income statement in that year; therefore, any related expense is recognized in the same period. That is the basic premise of the matching principle.
  • Second, the $100,000 gain creates a temporary difference. The amount will become taxable when the cash is collected in Year Five. At that time, a tax payment of $30,000 is required. Accountants have long debated whether this liability is created when the income is earned (Year One) or when the payment is to be made (Year Five). Legally, the company does not owe any money to the government until the Year Five income tax return is filed. However, reporting guidance provided by U.S. GAAP holds that recognition of the gain in Year One is the event that creates the probable future sacrifice. Thus, the liability is recognized immediately; a deferred income tax liability must be reported.

Consequently, the adjusting entry shown in Figure 15.11 “December 31, Year One—Recognition of Deferred Income Tax on Gain” is prepared at the end of Year One so that both the expense and the liability are properly reported.

Figure 15.11 December 31, Year One—Recognition of Deferred Income Tax on Gain

In Year Five, when the cash is received from the sale, Hill will report the $100,000 gain on its income tax return. The resulting $30,000 payment to the government eliminates the deferred income tax liability. However, as shown in Figure 15.11 “December 31, Year One—Recognition of Deferred Income Tax on Gain”, the income tax expense was reported back in Year One when the original sale was recognized for financial reporting purposes.

Test Yourself

Question:

A local business buys property for $80,000 and later sells it for $200,000. Payments will be collected equally over this year and the following three. The profit is recognized immediately for financial reporting purposes. For tax purposes, assume that this transaction qualified for use of the installment sales method. The business’s effective tax rate is 20 percent. What amount of deferred income tax liability should this entity recognize as of December 31, Year One?

  1. Zero
  2. $18,000
  3. $24,000
  4. $30,000

Answer:

The correct answer is choice b: $18,000.

Explanation:

The company makes a profit of $120,000 ($200,000-$80,000). Using the installment sales method, the gain is taxed when cash is collected. Because 25 percent of the cash is collected in the first year, $30,000 of that profit (25 percent × $120,000) is recognized immediately for tax purposes. Only the remaining $90,000 ($120,000 less $30,000) is deferred until later years for tax purposes. At a rate of 20 percent, the deferred tax liability is $18,000 ($90,000 × 20 percent).

Key Takeaway

U.S. GAAP and the Internal Revenue Code are created by separate groups with different goals in mind. Consequently, many differences exist as to amounts and timing of income recognition. The management of a business will try to use these differences to postpone payment of income taxes so that the money can remain in use and generate additional profits. Although payment is not made immediately, the matching principle requires the income tax expense to be reported in the same time period as the related revenue. If payment is delayed, a deferred income tax liability is created that remains in the financial records until the income becomes taxable. One of the most common methods for deferring income tax payments is application of the installment sales method. For financial reporting purposes, any gain is recorded immediately as is the related income tax expense. However, according to tax laws, recognition of the profit can be delayed until cash is collected. In the interim, a deferred tax liability is reported to alert decision makers to the eventual payment that will be required.

15.4 Reporting Postretirement Benefits

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Define the term “postretirement benefits.”
  2. Explain the accounting problems associated with the recognition of accrued postretirement benefits.
  3. List the steps that are followed to determine a company’s reported obligation for postretirement benefits.
  4. Identify the role of the actuary in accounting for postretirement benefits.
  5. Calculate a company’s debt-to-equity ratio and explain its meaning.
  6. Calculate the times interest earned ratio and explain its meaning.

Liability for Postretirement Benefits

Question: According to the information provided at the beginning of this chapter, Alcoa reported a $2.6 billion liability at the end of 2010 for accrued postretirement benefits. What constitutes a postretirement benefit?

 

Answer: In a note to the 2010 financial statements, Alcoa explains part of this liability as follows:

Alcoa also maintains health care and life insurance benefit plans covering eligible U.S. retired employees and certain retirees from foreign locations. Generally, the medical plans pay a percentage of medical expenses, reduced by deductibles and other coverages. These plans are generally unfunded, except for certain benefits funded through a trust. Life benefits are generally provided by insurance contracts. Alcoa retains the right, subject to existing agreements, to change or eliminate these benefits.”

Postretirement benefits cover a broad array of promises that companies make to their employees to boost morale and keep them from seeking other jobs. According to this note disclosure, Alcoa provides two of the most common: health care insurance and life insurance. Based on stipulations as to eligibility, Alcoa helps its employees by paying a portion of these insurance costs even after they have retired. Alcoa apparently continues to provide these payments as a reward for years of employee service.

Determining a Liability for Postretirement Benefits

Question: Assume that one of the employees for the Michigan Company is currently thirty-four years old and is entitled to certain postretirement benefits starting at the age of sixty-five. The company has promised to continue paying health care and life insurance premiums for all retirees as long as they live.Health care and life insurance benefits paid by an employer while an employee is still working do not pose an accounting issue. The costs are known and can be expensed as incurred. These expenses are matched with the revenues being generated by the employees at the current time. For this employee, no postretirement benefits will be paid for the next thirty-one years (65 less 34). After that, an unknown payment amount will begin and continue for an unknown period of time. In one of the opening chapters of this book, the challenge presented to accountants as a result of future uncertainty was discussed. Probably no better example of uncertainty can be found than postretirement benefits. Payments may continue for decades and neither their amount nor their duration is more than a guess.

The employee is helping the company generate revenues currently so that, as always, the related expense should be recognized now according to the matching principle. Although this obligation might not be paid for many years, both the expense and related liability are recorded when the person is actually working for the company and earning these benefits.

How is the amount of this liability possibly determined? An employee might retire at sixty-five and then die at sixty-six or live to be ninety-nine. Plus, estimating the cost of insurance (especially medical insurance) over several decades into the future seems to be a virtually impossible challenge. The skyrocketing cost of health care is difficult to anticipate months in advance, let alone decades. The dollar amount of the company’s obligation for these future costs appears to be a nebulous figure at best. In this textbook, previous liabilities have been contractual or at least subject to a reasonable estimation prior to recognition. How is the liability calculated that will be reported by a company for the postretirement benefits promised to its employees?

 

Answer: As shown by the Alcoa example, postretirement benefits are estimated and reported according to U.S. GAAP while employees work. Because of the length of time involved and the large number of variables (some of which, such as future health care costs, are quite volatile), a precise determination of this liability is impossible. In fact, this liability might be the most uncertain number found on any set of financial statements. Apparently, reporting a dollar amount for postretirement benefits, despite its inexactness, is more helpful than omitting the expense and liability entirely. However, decision makers need to understand that these reported balances are no more than approximations.

The actual computation and reporting of postretirement benefits is more complicated than can be covered adequately in an introductory financial accounting textbook. An overview of the basic steps, though, is useful in helping decision makers understand the information that is provided.

To arrive at the liability to be reported for postretirement benefits that are earned now but only paid after retirement, the Michigan Company takes two primary steps. First, an actuaryAn individual who mathematically computes the likelihood of future events. calculates an estimation of the cash amounts that will eventually have to be paid as a result of the terms promised to employees. “An actuary is a business professional who analyzes the financial consequences of risk. Actuaries use mathematics, statistics, and financial theory to study uncertain future events, especially those of concern to insurance and pension programs.”http://www.math.purdue.edu/academic/actuary/what.php?p=what. In simpler terms, an actuary is a mathematical expert who computes the likelihood of future events.

To make a reasonable guess at the amount of postretirement benefits, the actuary has to make a number of difficult estimations such as the average length of time employees will live and the future costs of health care and life insurance (and any other benefits provided to retirees). For example, an actuary’s calculations might indicate that these costs will average $10,000 per year for the twenty years that an employee is expected to live following retirement.

The future payments to be made by the company are estimated by an actuary, but they are projected decades into the future. Thus, as the second step in this process, the present value of these amounts is calculated to derive the figure to be reported currently on the balance sheet. Once again, as in previous chapters, interest for this period of time is determined mathematically and removed to leave just the principal of the obligation as of the balance sheet date. That is the amount reported by the employer within noncurrent liabilities.

Determining Accrued Postretirement Benefits
Step One: Estimate Future Payments
Step Two: Calculate Present Value of Estimated Future Payments

Test Yourself

Question:

The Johnson Corporation hires 100 employees in Year One. At that time, the organization makes a promise to each of its employees. If they will work for Johnson for twenty years, the company will pay for the college education of all their children. At that time, none of the employees has a child who will start college until after the next six years. Which of the following statements is true?

  1. The company should report an expense and a liability at the end of Year One.
  2. The company should start reporting an expense and a liability after six years.
  3. The company should start reporting an expense in Year One but no liability.
  4. The company will never report this promise as an expense and a liability.

Answer:

The correct answer is choice a: The company should report an expense and a liability at the end of Year One.

Explanation:

Johnson Corporation has begun to incur an expected cost in connection with future benefits for its employees. The related expense should be recognized beginning in Year One because these employees are working to generate revenues. An actuary can estimate the eventual cost of this promise based on the amount of work performed to date. A present value computation will then be made to determine the amount of this expense and liability that are applicable to the first year.

The Consequences of Having to Report a Liability

Question: Alcoa recognizes an accrued postretirement benefit liability on its balance sheet of $2.6 billion. This number is the present value of the estimated amounts that the company will have to pay starting when each employee retires. Except for the inherent level of uncertainty, this accounting seems reasonable. At one time decades ago, companies were not required to recognize this obligation. The liability was ignored and costs were simply expensed as paid. Only after advanced computer technology and sophisticated mathematical formulas became available was the reporting of this liability mandated. What is the impact of reporting postretirement benefits if the numbers can only be approximated?

 

Answer: Organizations typically prefer not to report balances that appear to weaken the portrait of their economic health and vitality. However, better decisions are made by all parties when relevant information is readily available. Transparency is a primary goal of financial accounting. Arguments can be made that some part of the problems that many businesses currently face are the result of promises that were made over past decades where the eventual costs were not properly understood.

As the result of the evolution of U.S. GAAP, decision makers (both inside and outside the company) can now better see the costs associated with postretirement benefits. Not surprisingly, once disclosed, some companies opted to cut back on the amounts promised to retirees. The note disclosure quoted previously for Alcoa goes on further to say, “All U.S. salaried and certain hourly employees hired after January 1, 2002 are not eligible for postretirement health care benefits. All U.S. salaried and certain hourly employees that retire on or after April 1, 2008 are not eligible for postretirement life insurance benefits” (emphasis added).

For the employees directly impacted, these decisions may have been understandably alarming. However, by forcing the company to recognize this liability, U.S. GAAP has helped draw attention to the costs of making such promises.

Test Yourself

Question:

On its most recent balance sheet, the Randle Company reports a noncurrent liability of $30 million as an accrued postretirement benefit obligation. Which of the following statements is least likely to be true?

  1. The amount to be paid will be more than $30 million.
  2. The company will have the $30 million in cash payments scheduled out at set times.
  3. The $30 million figure is a culmination of a number of difficult estimations.
  4. This liability could extend into the future for several decades.

Answer:

The correct answer is choice b: The company will have the $30 million in cash payments scheduled out at set times.

Explanation:

Postretirement benefits are amounts that a company will pay years into the future, often based on the life expectancy of retirees. After amounts are determined based on several estimates, cash payments are reduced to present value for reporting purposes. Because of the length of time involved, present value is often much less than the anticipated cash payments. Determination of the exact amount and timing of payments is subject to many variables that are not yet known such as life expectancy.

Vital Signs Studied in Connection with Liabilities

Question: In previous chapters, various vital signs have been examined—numbers, ratios, and the like—that assist decision makers in evaluating an entity’s financial condition and future prospects. In connection with liabilities, do specific vital signs exist that are frequently relied on to help assess the economic health of a business or other organization?

 

Answer: One vital sign that is often studied by decision makers is the debt-to-equity ratioA measure of a company’s use of debt for financing purposes; it is computed by dividing total liabilities by total stockholders’ equity.. This figure is simply the total liabilities reported by a company divided by total stockholders’ equity. The resulting number indicates whether most of a company’s assets have come from borrowing and other debt or from its own operations and owners. A high debt-to-equity ratio indicates that a company is highly leveraged. As discussed previously, that raises the level of risk but also increases the possible profits earned by stockholders. Relying on debt financing makes a company more vulnerable to bankruptcy and other financial problems but also provides owners with the chance for higher financial rewards.

Recent debt-to-equity ratios presented in Figure 15.12 “Recent Debt-to-Equity Ratios for Several Prominent Companies” for several prominent companies show a wide range of results. No single financing strategy is evident here. The debt-to-equity ratio indicates a company’s policy toward debt, but other factors are involved. For example, in some industries, debt levels tend to be higher than in others. Also, individual responses to the recent economic recession might have impacted some companies more than others.

Figure 15.12 Recent Debt-to-Equity Ratios for Several Prominent Companies

Another method to evaluate the potential problem posed by a company’s debts is to compute the times interest earned (TIE)A measure of a company’s ability to meet obligations as they come due; it is computed by taking EBIT (earnings before interest and taxes) and dividing that number by interest expense for the period. ratio. Normally, debt only becomes a risk if interest cannot be paid when due. This calculation helps measure how easily a company has been able to meet its interest obligations through current operations.

Times interest earned begins with the company’s net income before both interest expense and income taxes are removed (a number commonly referred to as “EBIT” or “earnings before interest and taxes”). Interest expense for the period is then divided into this income figure. For example, if EBIT is $500,000 and interest expense is $100,000, the reporting company earned enough during the year to cover the required interest obligations five times.

Figure 15.13 Recent Times Interest Earned for Several Prominent Companies

Test Yourself

Question:

The owners of a company contribute $100,000 to acquire its capital stock. Another $200,000 is borrowed from a bank. In its first year, the company earns a reported net income of $50,000. If the company then pays a cash dividend of $10,000, what is the impact of this distribution on the debt-to-equity ratio?

  1. There is no effect on the debt-to-equity ratio.
  2. It goes up. It was 1.33 to 1.00 and now is 1.43 to 1.00.
  3. It goes down. It was 1.33 to 1.00 and now is 1.25 to 1.00.
  4. It goes down. It was 1.43 to 1.00 and now is 1.33 to 1.00.

Answer:

The correct answer is choice b: It goes up. It was 1.33 to 1.00 and now is 1.43 to 1.00.

Explanation:

The company has one debt of $200,000. Before the dividend, stockholders’ equity is $150,000 ($100,000 in contributed capital and $50,000 in retained earnings). The debt-to-equity ratio is $200,000/$150,000 or 1.33 to 1.00. The dividend reduces retained earnings (this portion of net income is distributed to stockholders rather than leaving the assets in the business) to $40,000. Stockholders’ equity has dropped to $140,000. The debt-to-equity ratio is $200,000/$140,000 or 1.43 to 1.00.

Key Takeaway

Businesses and other organizations often promise benefits (such as health care and life insurance) to eligible employees to cover the years after they reach retirement age. Determining the liability balance to be reported at the current time poses a significant challenge for accountants because eventual payment amounts are so uncertain. An actuary uses historical data, computer programs, and statistical models to estimate these amounts. The present value of the projected cash payments is then calculated and recognized by the company as a noncurrent liability. The size of this debt can be quite large but the numbers are no more than approximations. Decision makers often analyze the level of a company’s debt by computing the debt-to-equity ratio and the times interest earned ratio. Both of these calculations help decision makers evaluate the risk and possible advantage of the current degree of debt financing.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: Lease arrangements are quite common in today’s business environment. For a capital lease, the present value of the future payments is reported by the lessee as a liability. In contrast, for an operating lease, only the amount currently due is included on the balance sheet as a liability. The reporting of such off-balance sheet financing has been criticized because businesses often go out of their way to create operating leases to minimize the total shown for their debts. However, information about these operating leases must be clearly disclosed in the notes to the financial statements. Are you concerned when you see a company with a lot of off-balance sheet financing? Would you prefer a system where companies had to report more of their debts from leasing arrangements? Do you believe off-balance sheet financing is a problem for the users of financial accounting information?

Kevin Burns: I hate off balance sheet financing. It is trickery in my opinion. As usual, I prefer full or even too much disclosure. A lease is a liability. It should be categorized as such. It is really quite simple—show the liability. Having information in the notes helps but liabilities should be reported on the balance sheet for all to see easily. Anything that reduces transparency is bad for the accounting industry and the people relying on reported financial information.

Obviously, I prefer for companies to have less debt. But, there are exceptions. I own a stake in a company that has a large building that has had a significant appreciation in value. Because they use that building, they cannot take advantage of that increase in value. I suggested to the management that they sell the building to get all of that money and then lease the building back so they could still use it. They would have to report the liability for the lease, but they get their money in a usable form right now, and they can remain in the building.

15.5 End-of-Chapter Exercises

Questions

  1. The Ace Company buys a large piece of equipment, which it immediately leases to Zebra Corporation for five years. Which company is the lessor and which company is the lessee?
  2. In simplest terms, what is an operating lease? In simplest terms, what is a capital lease?
  3. On December 31, Year One, a company agrees to pay $100,000 per year for the next nine years to lease a large piece of machinery. The first payment is made when the contract is signed. If the contract qualifies as an operating lease, what appears on this company’s balance sheet at December 31, Year One?
  4. Use the information in question 3 to explain the term “off-balance sheet financing.”
  5. On December 31, Year One, a company agrees to pay a set amount each year for six years to lease a large truck for hauling purposes. The first payment is made when the contract is signed. If this contract qualifies as a capital lease, what appears on this company’s balance sheet at December 31, Year One?
  6. A five-year lease is signed. At the end of that time, the lessee can buy the leased asset for an amount of money that is viewed as a bargain. Why does this option make the contract a capital lease?
  7. A lease is signed for property that has an expected life of ten years. The lease is for only eight years. Why does the length of this lease require the parties to record it as a capital lease?
  8. How many of the four official criteria must be met to require capital lease accounting?
  9. A company believes that its incremental borrowing rate is 7 percent. What is meant by the term “incremental borrowing rate?”
  10. A company is negotiating to lease an asset for use in its business operations. Why will company officials attempt to structure the agreement as an operating lease rather than as a capital lease?
  11. On January 1, Year One, the Atkins Corporation signs a four-year lease with the first payment made immediately. If this contract is an operating lease, what type of expense or expenses will be recognized at the end of Year One?
  12. On January 1, Year One, the Carleton Company signs a five-year lease with the first payment made immediately. If this contract is a capital lease, what type of expense or expenses will be recognized at the end of Year One?
  13. A company leases a building for eighteen years and records it as a capital lease. Why does the handling of this lease illustrate the desire of accountants to report substance over form?
  14. The Marlento Company reports net income in Year One for financial reporting purposes of $983,000. However, when the company prepares its income tax return for Year One, taxable income is shown as only $536,000. In general, why are these two income totals different?
  15. What is meant by the term “temporary tax difference?”
  16. The Wyndsoki Corporation reports a gain of $3 million in Year One. For income tax purposes, the gain is not taxable until Year Four. Will company officials be happy with this delay? Why or why not?
  17. The Lendmor Corporation earns income of $1.2 million in Year One before income taxes. However, by careful planning, all of this income has been deferred for tax purposes until Year Four. Assume that the tax rate is 30 percent. What adjusting entry, if any, is made for income taxes at the end of Year One?
  18. The Astomori Corporation buys land for $300,000 in Year One and sells it for $400,000 in Year Two. The company collects half of this money in Year Three and the other half in Year Four. Assume that the tax rate is 30 percent. In what year is the income tax expense recognized on this gain? What journal entry or adjusting entry is used to record the income tax expense at the end of Year Two?
  19. Jane Buenti-Jones is hired by the Cleveland Corporation. She is thirty years old. The company promises to pay her medical insurance while she works for the company and also after she retires. What is the accounting problem that the company faces here?
  20. The Abraham Company informs all employees that their life insurance will be paid by the company each year after they retire. What must be done to determine the amounts to be reported on the company’s financial statements in the current year?
  21. What role does an actuary play in accounting for postretirement benefits?
  22. What impact can the reporting of postretirement benefits have on company employees?
  23. A financial analyst mentions that a certain company reports EBIT of $1.4 million. What does EBIT represent?
  24. The James Company reports liabilities of $3.5 million and stockholders’ equity of $2.0 million. Then, just before the end of the current year, the company pays off a long-term liability with $500,000 in cash. What was the impact of that payment on James Company’s debt-to-equity ratio?
  25. A company reports a number of figures on its income statement including rent expense of $600,000, interest expense of $500,000, and income tax expense of $400,000. The company’s net income was shown as $1.8 million. Compute the times interest earned ratio for this company.

True or False

  1. ____ A lessee that is reporting the effects of a capital lease will record depreciation expense on the leased property.
  2. ____ A capital lease is a common example of off-balance sheet financing.
  3. ____ A lessee negotiates the lease of a piece of equipment. The lessee will likely attempt to structure the lease as an operating lease.
  4. ____ A lease has been signed that meets only two of the four criteria for a capital lease. Thus, this transaction will be recorded as an operating lease.
  5. ____ Lessees usually prefer to record leases as operating leases rather than capital leases.
  6. ____ Depreciation and interest are both recorded by a lessee in connection with a capital lease, but not an operating lease.
  7. ____ A lease is signed on December 31, Year One, that calls for annual payments of $20,000. The present value of these payments is $73,000. The lease is an operating lease. On its December 31, Year One, balance sheet, the company will record a liability of $53,000.
  8. ____ A lease contract is for six years although the asset has an expected life of twelve years. The lessee can buy the asset at the end of six years for $14,000. The lease has to be recorded as a capital asset.
  9. ____ On January 1, Year One, a lease is signed that is a capital lease. The cash payments are $10,000 per year starting on January 1, Year One. The present value of the cash flows before the first payment is $65,860. If the incremental borrowing rate is 10 percent, the lessee recognizes interest of $6,586 for the first year.
  10. ____ A company’s Year One income statement reports net income of $348,000. The company’s taxable income for that same year will also be $348,000.
  11. ____ If a gain is earned in Year One but taxed in Year Three, the related expense is reported in Year One.
  12. ____ If a gain is earned in Year One but taxed in Year Three, a deferred tax liability is reported at the end of Year One.
  13. ____ The deferral of income tax payments is viewed as a strategy for increasing reported net income.
  14. ____ When using the installment sales method for tax purposes, gains are generally taxed when the sale is made.
  15. ____ Postretirement benefits are not expensed until they are paid.
  16. ____ The liability recorded for postretirement benefits reflects a factual number that is known by company officials.
  17. ____ Because Melody Stuart works for a company this year, an expense will be recorded in connection with benefits that she will receive after her retirement in 2020.
  18. ____ Companies work to reduce their debt-to-equity ratio because of the risk that this figure reflects.
  19. ____ The computation of times interest earned is found by dividing interest expense for the period by the total amount of noncurrent liabilities.

Multiple Choice

  1. Wichita Corporation leases a large machine with a life of twenty years. Which of the following does not necessitate reporting this contract as a capital lease?

    1. The lease is only for sixteen years.
    2. At the end of the lease, Wichita can (but doesn’t have to) buy the machine at an amount significantly below expected fair value.
    3. At the end of twelve years, title to the machine goes to Wichita.
    4. Wichita will pay a smaller amount each year over a lease life of fourteen years.
  2. Sizemore Corporation leases a building to use for the next twenty years. Which of the following is true about Sizemore’s reporting?

    1. If this contract is a capital lease, rent expense is recognized each period.
    2. If this contract is an operating lease, depreciation expense is recognized each period.
    3. If this contract is an operating lease, interest expense and rent expense are recognized each period.
    4. If this contract is a capital lease, depreciation expense and interest expense are recognized each period.
  3. Albemarle Corporation leases a truck for six years and is trying to determine whether the contract qualifies as an operating lease or a capital lease. Which of the following is true?

    1. Albemarle will want the lease to be a capital lease because less interest is reported.
    2. Albemarle will want the lease to be a capital lease because less depreciation is reported.
    3. Albemarle will want the lease to be an operating lease because the reported liability will be lower.
    4. Albemarle will want the lease to be an operating lease because the reported asset balance will be larger.
  4. Myers Company leases a boat on January 1, Year One. The lease does qualify as a capital lease. The lease covers four years, with payments of $20,000 annually, beginning on January 1, Year One. The expected life of the boat is six years. Myers annual incremental borrowing rate is 5 percent. The present value of an ordinary annuity for four years at a 5 percent rate is $3.54595. The present value of an annuity due for four years at a 5 percent rate is $3.72325. What amount of depreciation (rounded) should Myers recognize on the boat for Year One if Myers chooses to use the straight-line method?

    1. $12,411
    2. $13,616
    3. $17,730
    4. $18,616
  5. Charlotte Company leases a piece of equipment on February 1. The lease covers two years although the life of the equipment is four years. The contract contains no bargain purchase option, the equipment does not transfer to Charlotte at the end of the lease, and the payments do not approximate the fair value of the equipment. The annual payments are $4,000 due each February 1, starting with the current one. Charlotte’s incremental borrow rate is 5 percent. The present value of an annuity due of $1 at a 5 percent interest rate for two years is $1.95238. What journal entry or entries should Charlotte make on February 1?

    1. Figure 15.14

    2. Figure 15.15

    3. Figure 15.16

    4. Figure 15.17

  6. On December 31, Year One, the Brangdon Corporation leases a truck to use in its operations. The truck has a life of ten years, although the lease is only for six years. Payments are $10,000 per year with the first payment made immediately. No interest payments are made but Brangsdon has an incremental borrowing rate of 9 percent. The present value of an annuity due at a 9 percent rate for six periods is $4.88965. The present value of an ordinary annuity at a 9 percent rate for six periods is $4.48592. If this is an operating lease, what figure is recorded initially as the capitalized cost of the truck?

    1. Zero
    2. $38,897
    3. $44,859
    4. $48,897
  7. On December 31, Year One, the Sliyvoid Corporation leases a large machine for five years, its entire expected life. Depreciation is recorded using the straight-line method. Payments are $12,000 per year starting on December 31, Year One, and every December 31 thereafter. The incremental borrowing rate is 10 percent per year. The present value of an annuity due at a 10 percent rate for five periods is $4.16987. The present value of an ordinary annuity at a 10 percent rate for five periods is $3.79079. What is the net book value of the leased asset on December 31, Year Two?

    1. $30,431
    2. $36,392
    3. $37,875
    4. $40,030
  8. Use the same information as in problem 7. Determine the interest expense to be recognized in Year Two.

    1. $3,349
    2. $3,804
    3. $4,549
    4. $5,004
  9. Use the same information as in problem 7. Determine the lease liability to be reported on the company’s balance sheet at the end of Year Two.

    1. $24,838
    2. $29,842
    3. $38,038
    4. $43,042
  10. On December 31, Year One, Company A leases a car for four years and pays $10,000 per year with the first payment made immediately. Company A believes the asset has a life of six years and records it as an operating lease. On December 31, Year One, Company B leases an identical car for four years and pays $10,000 per year with the first payment made immediately. Company B believes the asset has a life of five years and records it as a capital lease. The straight-line method of depreciation is used. Both companies have an annual incremental borrowing rate of 5 percent. The present value of an annuity due of $1 over four years at a 5 percent interest rate is $3.7232. Which of the following is true?

    1. Company B will report more expense in Year Two than Company A by $670.
    2. Company B will report more expense in Year Two than Company A by $1,120.
    3. Company A will report more expense in Year Two than Company B by $840.
    4. Company A will report more expense in Year Two than Company B by $1,250.
  11. Potslitini Corporation has a large amount of income that is earned in Year One but will not be subject to income taxes until Year Three. Which of the following statements is true for financial reporting purposes?

    1. The income tax expense is reported when the income appears on the company’s income tax return.
    2. The income tax expense is reported when the tax money is physically paid to the government.
    3. The income tax expense is reported in Year One when the income is earned.
    4. The income tax expense can only be reported in this problem in Year Three.
  12. Fargo Corporation earns revenue in Year One that will be reported on its Year One income statement but will not be reported on its tax return until Year Three. This revenue amounts to $800,000, and Fargo’s tax rate is 40 percent. Which of the following statements is true?

    1. Fargo should report a deferred tax liability of $800,000 at the end of Year One.
    2. Fargo should not recognize any deferred tax liability until Year Three.
    3. Fargo should report a deferred tax liability of $320,000 at the end of Year One.
    4. Fargo should recognize a deferred tax liability when the payment is eventually paid.
  13. The Sinson Company buys land in Year One for $90,000 and then sells it in Year Two for $200,000. The company will collect this money in Year Four. For income tax purposes, Sinson will use the installment sales method. Sinson has a tax rate of 40 percent. Which of the following statements is true?

    1. Sinson records an income tax expense of $36,000 in Year Two.
    2. Sinson records an income tax expense of $80,000 in Year Four.
    3. Sinson records a deferred income tax liability of $44,000 at the end of Year Two.
    4. Sinson records a deferred income tax liability of $80,000 at the beginning of Year Four.
  14. Which of the following is not a true statement about postretirement benefits?

    1. A company’s liability for postretirement benefits is quite difficult to estimate.
    2. An expense for an employee’s future postretirement benefits should be recognized during the period the employee helps generate revenue.
    3. The liability for postretirement benefits is reported at its present value.
    4. The liability reported for postretirement benefits represents the actual amount that will have to be paid.
  15. At the start of Year One, the Arkansas Company promises all employees that it will pay their medical insurance after they retire. As a result, company officials realize that a liability will have to be reported. This promise is expected to cost the company a total cash amount of $3.3 million over the next 30 years. Who most likely determined this figure?

    1. An attorney.
    2. An insurance agent.
    3. An actuary.
    4. The head of the employee group.
  16. Use the information in problem 15. What liability does Arkansas have to report at the end of Year One?

    1. $3.3 million
    2. $110,000
    3. The present value of $3.3 million
    4. Zero
  17. On its latest balance sheet, the Sellers Corporation reports assets of $450,000 and liabilities of $200,000. What is Sellers’ debt-to-equity ratio?

    1. 0.44 to 1.00
    2. 0.80 to 1.00
    3. 1.25 to 1.00
    4. 2.25 to 1.00
  18. The Xi Company is started at the beginning of Year One when its owners contribute $120,000 in cash. The company reports net income of $70,000 and pays cash dividends of $10,000 every year thereafter. At the end of Year Three, the company reports total assets of $900,000. On that date, what is the debt-to-equity ratio?

    1. 1.00 to 1.00
    2. 2.00 to 1.00
    3. 3.00 to 1.00
    4. 3.33 to 1.00
  19. A company has a debt-to-equity ratio of 3.00 to 1.00. The company pays a cash dividend of $62,000. What is the impact on the debt-to-equity ratio?

    1. The debt-to-equity ratio will increase.
    2. The debt-to-equity ratio will decrease.
    3. The debt-to-equity ratio will not be affected.
    4. No determination of the impact on the debt-to-equity ratio can be made with the information provided.
  20. Hyde Corporation has long-term liabilities, such as bonds, notes and leases, for which interest expense must be accrued. During Year One, Hyde reported net income of $65,000 after income taxes of $15,000 and interest expense of $10,000. Which of the following is Hyde’s times interest earned?

    1. 6.5 times
    2. 7.5 times
    3. 8.0 times
    4. 9.0 times

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while walking over to the computer lab your roommate poses this question: “My parents just signed a contract to lease a new shop in Tampa. It is in a great location so they are going to pay $120,000 each year to lease this facility for 10 years. That’s $1.2 million. However, they were telling me that they will not have to report this liability on their financial statements. That makes no sense to me. They have a contract that requires them to pay over $1 million in the future. How could they possibly not have to report that as a liability?” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has grown and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We always want to make sure that our financial statements and our tax returns are done properly. Several years ago we bought some land and built a store on it. However, we didn’t use all the land, so this year we sold several extra acres. The land had really appreciated in value, and we made a very large gain. We made the sale this year, but the payments will not start for a couple of years. Our accountant tells us that we have to report the related income tax expense this year, but we don’t have to pay the government anything until we start getting the money. That doesn’t sound right. It seems to me that the expense and the payment should be at the same time. Can you explain what is going on here because I really don’t want to get into any trouble?” How would you respond?

Problems

  1. On October 1, Year One, United Company leases an office space in a downtown building. This contract qualifies as an operating lease. United pays $30,000 in advance for rent every year. Record journal entries and adjusting entries for United for the following dates in connection with this property.

    1. October 1, Year One.
    2. December 31, Year One.
    3. September 30, Year Two.
  2. Ralph Corporation agreed to lease a piece of equipment to Amy Company on January 1, Year One. The following information relates to this lease:

    • The lease term is five years, at the end of which time the equipment will revert back to Ralph. The life of the equipment is expected to be six years.
    • Payments of $90,000 will be due at the beginning of each year, with the first payment to be made at the signing of the lease.
    • Amy’s incremental borrowing rate is 8 percent. The present value of a single payment of $1 in five years at an annual interest rate of 8 percent is $0.68058. The present value of an ordinary annuity of $1 for five years at an annual interest rate of 8 percent is $3.99271. The present value of an annuity due of $1 for five years at an annual interest rate of 8 percent is $4.31213.

      Prepare the following journal entries for Amy.

      1. Record the signing of the lease on January 1, Year One.
      2. Record the first payment on January 1, Year One.
      3. Record depreciation on the equipment on December 31, Year One.
      4. Record interest on the liability on December 31, Year One.
      5. Record the second payment on January 1, Year Two.
  3. On January 1, Year One, Landon Corporation decides to lease a truck for $20,000 per year for three years. The annual incremental borrowing rate for Landon is 10 percent. The truck has a life of five years. Landon cannot buy or obtain title to the truck. The present value of an annuity due of $1 for three years at an annual interest rate of 10 percent is $2.73554. At the last moment, Landon changes the contract to four years instead of three. No other changes are made. The present value of an annuity due of $1 for four years at an annual interest rate of 10 percent is $3.48685.

    1. How did the change from three years to four years affect the expense to be reported by Landon in Year One?
    2. How did the change from three years to four years affect the expense to be reported by Landon in Year Two?
    3. After changing the contract to four years, what net book value will be shown for the leased truck at the end of Year One?
    4. After changing the contract to four years, what lease liability balance will be shown at the end of Year One?
  4. On December 31, Year One, the Abertion Company decides to lease a piece of equipment rather than buy it. The lease is for 10 years. Payments are $22,000 each December 31 beginning on December 31, Year One. Abertion has an annual incremental borrowing rate of 9 percent. The present value of an annuity due of $1 at 9 percent for 10 periods is $6.99525.

    1. Assume this lease is an operating lease. What journal entries are made in Year One and Year Two?
    2. Assume this lease is an operating lease. What is shown on the company’s balance sheet at the end of Year Two?
    3. Assume this lease is a capital lease. What journal entries are made in Year One and Year Two?
    4. Assume this lease is a capital lease. What is shown on the company’s balance sheet at the end of Year Two?
  5. The Addams Corporation is preparing to lease several large pieces of equipment. The president has asked the company’s accountant to respond to the following questions about lease accounting.

    1. How will Addams know if the lease is an operating lease or a capital lease?
    2. What is meant by off-balance sheet financing? How does off-balance sheet financing relate to the reporting of leases?
    3. Why is a discussion of substance over form often heard in connection with the financial reporting of a capital lease?
  6. On January 1, Year One, Lori Inc. signed a five-year capital lease for the use of an asset. Payments are $5,000 on each January 1, beginning with Year One. Lori’s incremental borrowing rate is 6 percent. The present value of an annuity due of $1 at 6 percent for 5 periods is $4.46511.

    1. Determine Lori’s interest expense for Year One.
    2. Assume Lori’s reported earnings for Year One before interest and taxes are $18,224. Determine Lori’s times interest earned.
    3. Assume that on January 1, Year One, before signing this lease agreement, Lori reported assets of $500,000 and liabilities of $220,000. What impact did signing this contract have on the company’s debt-to-equity ratio?
  7. At December 30, Year One, the Eighorn Corporation has net income (and taxable income) of $400,000. The company has an effective tax rate of 30 percent. Taxes have not yet been recorded. Then, on the last day of the year, the company sells land that it bought several years ago for $70,000. The sales price is $300,000. The money will be collected in Year Three. The company opts to use the installment sales method to report this transaction for tax purposes.

    1. What does the company now report as its net income for Year One?
    2. When is the liability for the income tax on the gain on the sale of the land reported? Why is this timing appropriate?
  8. The Yellow Corporation reports a deferred income tax liability of $732,000 in its December 31, Year One, balance sheet.

    1. Why are differences created between a company’s reported net income and the taxable income figure shown on its income tax return?
    2. What is meant by the term “temporary tax difference”?
    3. In general, what is the meaning of a deferred income tax liability?
    4. In analyzing a company, liabilities are generally viewed as a negative. Why do company officials attempt to create deferred income tax liabilities?
  9. The Greene Company has net income before income tax expense of $300,000 in Year One. However, because of differences between U.S. GAAP and the tax laws, only 60 percent of this income is taxed in Year One (to be paid on March 15, Year Two). Another 30 percent will be taxed in Year Two and the final 10 percent will be taxed in Year Nine. Assume the effective tax rate is 25 percent.

    1. What adjusting entry is recorded at the end of Year One?
    2. What amount of net income should be reported by Greene Company for Year One?
  10. The Bleu Company reports a liability for “postretirement benefits” of $14 million on its December 31, Year One, balance sheet.

    1. Explain how this obligation was created.
    2. In determining this liability of $14 million, company officials worked their way through two steps. Describe those two steps.
    3. Some companies might argue that this liability should not be reported on a balance sheet. What argument would they use for this position?
  11. Myrtle Inc. begins Year One with liabilities of $456,000 and stockholders’ equity of $320,000. On the first day of Year One, the following occur:

    • Myrtle enters into an operating lease where it agrees to pay $50,000 per month for warehouse space. The contract is signed, and the first payment is made.
    • Myrtle borrows $103,000 in cash from Community Bank.
    • Several owners invest a total of $57,000 in cash into the company.
    1. Determine Myrtle’s debt-to-equity ratio before the above transactions occur.
    2. Determine Myrtle’s debt-to-equity ratio considering the effect of the above transactions.
  12. In several past chapters, we met Heather Miller, who started her own business, Sew Cool. The following are the financial statements for December.

    Figure 15.18 Sew Cool Financial Statements

    Figure 15.19

    Figure 15.20

    Based on the financial statements determine the following:

    1. Debt-to-equity ratio.
    2. Times interest earned.

Comprehensive Problem

This problem will carry through several chapters, building in difficulty. It allows students to continually practice skills and knowledge learned in previous chapters.

In Chapter 14 “In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds?”, financial statements for February were prepared for Webworks, They are included here as a starting point for the required recording for March.

Figure 15.21 Webworks Financial Statements

Figure 15.22

Figure 15.23

The following events occur during March:

  1. Webworks starts and completes seven more sites and bills clients for $5,000.
  2. Webworks purchases supplies worth $110 on account.
  3. At the beginning of March, Webworks had nineteen keyboards costing $118 each and twenty flash drives costing $22 each. Webworks uses periodic FIFO to cost its inventory.
  4. On account, Webworks purchases eighty keyboards for $120 each and one hundred flash drives for $23 each.
  5. Webworks sells eighty-five keyboards for $12,750 and ninety-two of the flash drives for $2,760 cash.
  6. Webworks collects $5,000 in accounts receivable.
  7. Webworks pays off $12,000 of its accounts payable.
  8. Leon Jackson (the company’s owner) determines that some of his equipment is not being used and sells it. The equipment sold originally cost $2,000 and had accumulated depreciation of $297. Webworks sold the equipment for $1,650 cash.
  9. Webworks pays Nancy Po (company employee) $750 for her work during the first three weeks of March.
  10. Leon Jackson and Nancy Po are having trouble completing all their work now that the business has grown. Another assistant, Juan Marcon, is hired. Webworks pays Juan $550 for his help during the first three weeks of March.
  11. Webworks writes off an account receivable from December in the amount of $200 because collection appears unlikely.
  12. Webworks pays off its salaries payable from March.
  13. Webworks pays Leon Jackson a salary of $3,500.
  14. Webworks completes the design for the bakery but not the photographer for which it was paid in February. Only $300 of the unearned revenue should be reclassified to revenue.
  15. Webworks decides that more space is needed than that which is available in the home of Leon’s parents (much to his parents’ relief). His parents return the $200 he prepaid for March. Webworks signs a six-month lease in a nearby office building. Webworks will pay $500 at the beginning of each month, starting on March 1. The life of the building is forty years, and no bargain purchase option exists, nor do the payments come close to paying the market value of the space.
  16. Webworks pays taxes of $580 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for March.
    4. Prepare adjusting entries for the following and post them to your T-accounts.
  17. Webworks owes Nancy $200 and Juan $150 for their work during the last week of March.
  18. Webworks receives an electric bill for $400. Webworks will pay the bill in April.
  19. Webworks determines that it has $50 worth of supplies remaining at the end of March.
  20. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  21. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method.
  22. The license agreement should be amortized over its one-year life.
  23. QRS Company is selling for $13 per share and RST Company is selling for $18 per share on March 31.
  24. Interest should be accrued for March.
  25. Record cost of goods sold.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements for March.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in SuperValu Inc. The partner is aware that SuperValu uses a lot of stores and, therefore, probably has to lease many of those sites. The partner is curious as to whether these leases are mostly capital leases or operating leases. The partner asks you to look at the 2011 financial statements for SuperValu by following this path:

  • Go to http://www.supervalu.com.
  • At the top right side of this screen, click on “About Us.”
  • On the right side of the next screen, click on “Investors.”
  • On the right side of the next screen, click on “Annual Report and Proxy Statement.”
  • On the next screen, click on “2011 Annual Report on 10K” to download.
  • Scroll to page 36 and find the company’s balance sheet as of February 26, 2011. Look at the liability section of the balance sheet and see what information is reported about “capital lease obligations.”
  • Scroll down to “Note 6 – Long-Term Debt” and “Note 7 – Leases.” They begin on page 47. Read through the information that is provided.
  1. As of the balance sheet date, what is the company reporting as its “capital lease obligations?”
  2. In the future, how much cash will the company have to pay on its operating leases?
  3. In the future, how much cash will the company have to pay on its capital lease obligations?

Chapter 14: In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds?

14.1 Debt Financing

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. List and explain the advantages of debt financing.
  2. List and explain the disadvantages of debt financing.
  3. Describe and illustrate the use of financial leverage.
  4. Define notes and bonds as used in debt financing.

The Cost and Risk of Debt

Question: Businesses and other organizations need monetary funds to finance their operations and possible expansions. Such amounts can be quite significant. A portion of these resources normally come from investors who choose to become owners through the purchase of shares of capital stock directly from the company. Monetary amounts can also be generated internally by means of profitable operations. If net income each period exceeds the dividends that are paid to stockholders, a company has an ongoing source of financing.

However, many companies obtain a large part of the funding needed to support themselves and their growth through borrowing. If those debts will not be paid within the following year, they are listed on the balance sheet as noncurrent liabilities. The Xerox Corporation, for example, listed noncurrent liabilities on its December 31, 2010, balance sheet of $11.7 billion.

Creditors expect their entire loan balance to be repaid plus interestThe charge for using money over time, often associated with long-term loans; even if not specifically mentioned in the debt agreement, financial accounting rules require it to be computed and reported based on a reasonable rate. at the specified due date. The money has to be available. Consequently, incurring debts of such large amounts exposes the organization to risks. What problems and potential dangers does an entity face when liabilities—especially those of significant size—are owed?

 

Answer: Few things in life are free. The most obvious problem with financing an organization through debt is that it has a cost. A bank or other creditor will demand interest in exchange for the use of its money. For example, Xerox Corporation reported interest expense for the year ending December 31, 2010, of approximately $592 million. The rate of interest charged on debt will vary based on economic conditions and the perceived financial health of the debtor. As should be expected, strong companies are able to borrow money at a lower rate than weaker ones.

In addition, debt brings risk. A business must be able to generate enough surplus cash to satisfy creditors as liabilities come due. Xerox owes noncurrent liabilities of $11.7 billion. Eventually, company officials will have to find sufficient money to satisfy these obligations. Those funds might well be generated by profitable operations or contributed by investors. Or Xerox may simply borrow more money to pay off debts as they mature. This type of rollover financing is common but only as long as the debtor remains economically strong. Whatever the approach, the company has to manage its financial resources in such a way that all debts are settled in a timely manner.

The most serious risk associated with debt financing is the possibility of bankruptcy. As has become unfortunately commonplace during the recent economic crisis, organizations that are unable to pay their liabilities can be forced into legal bankruptcy.A company can seek protection from its creditors by voluntarily asking the court to allow it to enter bankruptcy. Or, three creditors holding a minimum amount of debt can push a company into bankruptcy, an event known as an involuntary bankruptcy filing. The end result of bankruptcyA formal court process that often results in the liquidation of a debtor’s assets when it cannot pay liabilities as they come due; in some cases, bankrupt companies are allowed to reorganize their finances and continue operations so that liquidation is not necessary. is frequently the liquidation of company assets with the distribution of those proceeds to creditors. However, under U.S. law, financial reorganization and continued existence is also a possibility. When Circuit City entered bankruptcy, company officials tried to reorganize to save the company. Eventually, Circuit City sold its assets and went out of business. In contrast, Delta Air Lines was able to leave bankruptcy protection in 2007 as a business that had been completely reorganized in hopes of remaining a viable entity.Information on the bankruptcy and subsequent legal reorganization of Delta Air Lines can be found at http://money.cnn.com/2007/04/30/news/companies/delta_bankruptcy/index.htm.

Given the cost and risk associated with owing large amounts of debt, the desire of decision makers to receive adequate and clear information is understandable. Few areas of financial accounting have been more discussed over the decades than the reporting of noncurrent liabilities.

The Benefits of Debt Financing

Question: Debt is a costly and possibly risky method of financing a company’s operations and growth. Some advantages must exist or no company would ever incur any noncurrent liabilities. What are the advantages to an organization of using debt to generate funding for operations and other vital activities?

 

Answer: One advantage of borrowing money is that interest expense is tax deductible. A company will essentially recoup a significant portion of all interest costs from the government. As mentioned above, Xerox incurred interest expense of $592 million. This interest reduced the company’s taxable income by that amount. If the assumption is made that Xerox has an effective income tax rate of 35 percent, the total amount paid to the government is lowered by $207.2 million (35 percent times $592 million). Xerox pays interest of $592 million, which reduces its income taxes by $207.2 million so that the net cost of borrowing for the period was $384.8 million.

Another advantage associated with debt financing is that it can be eliminated. Liabilities are not permanent. If the economic situation changes, a company can rid itself of all debt by making payments as each balance comes due. In contrast, if money is raised by issuing capital stock, the new shareholders can maintain their ownership indefinitely.

However, the biggest advantage commonly linked to debt is the benefit provided by financial leverageA company’s ability to earn more on borrowed money than the associated interest cost so that net income increases; often viewed as a wise business strategy although risks (such as possible bankruptcy) are elevated.. This term refers to an organization’s ability to increase its reported net income by earning more money on borrowed funds than the associated cost of interest. For example, if a company borrows $1 million on a debt that charges interest of 5 percent per year, annual interest is $50,000. If the $1 million that is received can be used to generate profit of $80,000 (added revenue minus added operating expenses), net income has gone up $30,000 ($80,000 – $50,000) using funds provided solely by creditors. The owners did not have to contribute any additional funds to increase profits by $30,000.

Over the decades, many companies have adopted a strategy of being highly leveraged, meaning that most of their funds come from debt financing. If profitable, the owners can earn huge profits with little or no investment of their own. Unfortunately, companies that take this approach face a much greater risk of falling into bankruptcy because of the large amounts of interest that have to be paid at regular intervals.

Test Yourself

Question:

James Thorpe invests $100,000 to start a new business. He immediately borrows another $400,000 at a 6 percent annual interest rate. The business earns a profit on its assets of 10 percent per year. At the end of one year, Thorpe liquidates all assets at book value and closes the business. What rate of return did he earn on this investment during this year of operations? Ignore income taxes.

  1. 10 percent
  2. 14 percent
  3. 15 percent
  4. 26 percent

Answer:

The correct answer is choice d: 26 percent.

Explanation:

The business is heavily debt financed; 80 percent of assets came from debt. Assets of $500,000 earn a profit of 10 percent, or $50,000. Interest cost is only $24,000 ($400,000 × 6 percent). The profit is $26,000 ($50,000 less $24,000). A profit of $26,000 is earned from the owner’s investment of $100,000, a return of 26 percent in one year. A profit of 10 percent was made from borrowed funds that cost 6 percent to obtain. The residual profit goes to the owners. This is financial leverage.

Raising Funds by Issuing Notes and Bonds

Question: Long-term financing typically comes from the issuance of notes or bonds. What are notes and bonds and how do they differ from each other?

 

Answer: Both notes and bonds are written contracts (often referred to as indentures) that specify the payment of designated amounts of cash by the debtor on stated dates. The two terms have become somewhat interchangeable over the years and clear distinctions are not likely to be found in practice.

  • In this textbook, for convenience, the term “note” is used when a contract is negotiated directly between two parties. For example, assume officials from Jones Company go to City Street Bank and borrow $1.2 million to construct a new warehouse. The contract between these parties to establish the specific requirements of this loan agreement will be referred to as a note.
  • The term “bond” will be used to describe a contract or group of contracts created by a debtor and then issued for money, often to members of the general public. Jones Company could opt to raise the $1.2 million needed for its new warehouse by printing 1,200 $1,000 bonds that it then sells to a wide array of creditors around the world. Such bonds are prepared in a wide variety of denominations.

Typically, the issuance of debt to multiple parties enables a company to raise extremely large amounts of money. A news story from the end of 2010 confirms the magnitude of these transactions: “Corporate bond sales worldwide topped $3 trillion for a second straight year.”Tim Catts and Sapna Maheshwari, “GE Leads $3.19 Trillion in Corporate Bond Sales: Credit Markets,” December 30, 2010, http://www.bloomberg.com/news/2010-12-30/ge-leads-3-trillion-in-company-bond-sales-as-yields-fall-credit-markets.html. If securities are being issued to the public in this way, the legal rules and regulations of the U.S. Securities and Exchange Commission must be followed, which adds another layer of cost to the raising of funds.

Key Takeaway

Most companies have a periodic need to raise money for operations and capital improvements. Debt financing is common for this purpose, although it leads to an interest charge and increased risk, even the possibility of bankruptcy. The cost of debt is offset somewhat because interest expense is tax deductible. Incurring liabilities also allows a business to use financial leverage to boost reported profits but only if the proceeds received generate more income than the cost of the related interest. Notes and bonds are debt contracts that spell out the specific legal rights and responsibilities of both parties. In this textbook, notes will indicate that loans have been negotiated between two parties whereas bonds will refer to debt instruments that are issued, often to the public.

14.2 Issuance of Notes and Bonds

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Identify common terms found in a note or bond contract such as face value, stated cash interest rate, and various types of security agreements or covenants.
  2. Record notes and bonds that are issued at face value where periodic interest payments are made on dates other than the year-end.
  3. Explain the handling of notes and bonds that are sold between interest dates and make the journal entries for both the issuance and the first interest payment.

Debt Contracts

Question: Notes and bonds are contracts that facilitate the borrowing of money. They are produced with great care by attorneys who are knowledgeable in contract law. What legal terms are typically included in a debt instrument?

 

Answer: The specific terms written into a loan indenture vary considerably depending on what a debtor is willing to promise in hopes of enticing a creditor to turn over needed financial resources. Some of the most common are as follows.

Face valueMonetary amount of a note or bond to be repaid at the end of the contract; it serves as the basis for computing interest payments and is also known as the maturity value. (or maturity value). The noteA written contract to convey money as a loan at a specified interest rate and repayment schedule between two parties. or bondA written contract created by a debtor that is issued (to specific parties or to the members of the general public) to raise money; the contract specifies the amount and time of repayment as well as other terms and covenants promised by the debtor. will specify the amount to be repaid at the end of the contract term. A $1,000 bond, for example, has a face value of $1,000—the payment to be made on a designated maturity date. The face value can be set at any figure of the debtor’s choosing.

Payment pattern. With some debts, no part of the face value is scheduled for repayment until the conclusion of the contract period. These loans are often referred to as term notes or term bondsA type of debt instrument where interest is paid at regular time intervals with the entire face value due at the end of the contract period.. The entire amount of the face value is paid when the contract reaches the end of its term (sometimes referred to as a balloon payment). For many debtors, accumulating this amount of cash at one time might pose a significant financial burden.

Other loans, known as serial debtsA type of debt instrument where a set repayment is to be made each period to cover both interest and a portion of the face value; home mortgages and automobile loans are common examples., require many individual payments of the face value to be made periodically over time. Home mortgages, for example, are commonly structured as serial notes. Part of each scheduled payment reduces the face value of the obligation so that no large amount remains to be paid on the maturity date.

Notes and bonds can also be set up to allow the debtor the choice of repaying part or all of the face value prior to the due date. Such debts are referred to as “callable.” This feature is popular because it permits refinancing if interest rates fall. If a new loan can be obtained at a cheaper interest rate, the money is used to pay off any callable debt that charges a higher interest rate. Sometimes a penalty payment is required if a note or bond is paid prematurely.

Interest rate. Creditors require the promise of interest before they are willing to risk loaning money to a debtor. Therefore, within the debt contract, a stated cash interest rateThe rate for interest on a debt can be identified by any of several terms. Cash rate, stated rate, contract rate, and coupon rate are all examples of the same information: the rate of interest to be paid by the debtor at specified times. is normally included. A loan that is identified as having a $100,000 face value with a stated annual interest rate of 5 percent informs both parties that $5,000 in interest ($100,000 × 5 percent) will be conveyed from debtor to creditor each year.

For example, the 2010 financial statements for the Intel Corporation indicated that the company had issued over $1 billion in bonds during 2009 that paid a stated annual interest ratePercentage rate established in a debt contract to be paid by the debtor in addition to the face value usually at specified time intervals; it is also called the cash rate, contract rate or coupon rate. of 3.25 percent with a maturity date in 2039.

Interest payment dates. The stated amount of interest is paid at the times identified in the contract. Payments can range from monthly to quarterly to semiannually to annually to the final day of the debt term.

Security. Many companies are not able to borrow money (or cannot borrow money without paying a steep rate of interest) unless some additional security is provided for the creditor. Any reduction of risk makes a note or bond instrument more appealing to potential lenders.

For example, some loans (often dealing with the purchase of real estate) are mortgage agreements that provide the creditor with an interest in identified property. Although specific rights can vary based on state law and the wording of the contract, this type of security usually allows the creditor to repossess the property or force its liquidation if the debtor fails to make payments in a timely manner. The recent downturn in the housing market has seen many debtor defaults that have led to bank foreclosures on homes across the country because of such mortgage agreements.

debentureA debt contract that does not contain any type of security for the creditor; these contracts are usually offered by debtors that are considered financially strong so that no additional security is required by creditors to reduce their chance of loss. is a debt contract that does not contain any security. The debtor is viewed as so financially strong that money can be obtained at a reasonable interest rate without having to add extra security agreements to the contract.

CovenantsPromises made by the issuer of a debt contract to help ensure that sufficient money will be available to make required payments at their scheduled times. and other terms. Notes and bonds can contain an almost infinite list of other agreements. In legal terms, a covenant is a promise to do a certain action or a promise not to do a certain action. Most loan covenants are promises made by the debtor to help ensure that adequate money will be available to make required payments when they come due. For example, the debtor might agree to limit the size of any dividend payments, keep its current ratio above a minimum standard, or not exceed a maximum amount of debt.

Debts can also be convertible so that the creditor can swap them for something else of value (often the capital stock of the debtor) if that seems a prudent move. The notes to the financial statements for the Ford Motor Company as of December 31, 2010, and the year then ended describe one such noncurrent liability. “At December 31, 2010, we had outstanding $883 million principal of 4.25% Senior Convertible Notes due December 15, 2016 (‘2016 Convertible Notes’). The 2016 Convertible Notes pay interest semiannually at a rate of 4.25% per annum. The 2016 Convertible Notes are convertible into shares of Ford Common Stock, based on a conversion rate (subject to adjustment) of 107.5269 shares per $1,000 principal amount.”

Recording a Note Issued at Face Value

Question: The financial reporting of a debt contract appears to be fairly straightforward. Assume, for example, that Brisbane Company borrows $400,000 in cash from a local bank on May 1, Year One. The face value of this loan is to be repaid in exactly five years. In the interim, interest payments at an annual rate of 6 percent will be made every six months beginning on November 1, Year One. What journal entries are appropriate to record a debt issued for a cash amount equal to the face value of the contract?

 

Answer: Brisbane receives $400,000 in cash but also accepts a noncurrent liability for the same amount. The resulting journal entry is shown in Figure 14.1 “May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable”.

Figure 14.1 May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable

The first semiannual interest payment will be made on November 1, Year One. Because the 6 percent interest rate stated in the contract is for a full year, it must be adjusted to calculate the payment that covers each six-month interval. These payments will be for $12,000 ($400,000 face value × 6 percent annual stated interest rate × 6/12 year). The recording of the first payment is presented in Figure 14.2 “November 1, Year One—Payment of Interest for Six Months”.

Figure 14.2 November 1, Year One—Payment of Interest for Six Months

By December 31, Year One, when financial statements are to be prepared, interest for two additional months (November and December) has accrued. This amount ($4,000 or $400,000 × 6 percent × 2/12 year) is recognized at that time so (a) the amount due on the balance sheet date will be presented fairly and (b) the cost of the debt for these two months is included on the Year One income statement. No transaction occurs on that date but the adjusting entry in Figure 14.3 “December 31, Year One—Accrual of Interest for Two Months” brings all reported figures up to date.

Figure 14.3 December 31, Year One—Accrual of Interest for Two Months

When the next $12,000 interest payment is made by Brisbane on May 1, Year Two, the recorded $4,000 liability is extinguished and interest for four additional months (January through April) is recognized. The appropriate expense for this period is $8,000 ($400,000 × 6 percent × 4/12 year). Mechanically, this payment could be recorded in more than one way but the journal entry shown in Figure 14.4 “May 1, Year Two—Payment of Interest for Six Months” is probably the easiest to follow. Interest expense for the first two months was recorded in Year One with interest for the next four months recorded here in Year Two.

Figure 14.4 May 1, Year Two—Payment of Interest for Six Months

Interest payments and the recording process will continue in this same way until all five years have passed and the face value is paid.

Except for the initial entry, these events are recorded in an identical fashion if Brisbane had signed this same note to acquire an asset—such as a piece of machinery—directly from the seller. The only reporting difference is that the asset replaces cash in Figure 14.1 “May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable” above.

Test Yourself

Question:

On January 1, Year One, the Leaver Company signs a nine-year note payable with a face value of $800,000 and a stated annual cash interest rate of 7 percent. Interest will be paid annually beginning on January 1, Year Two. Which of the following statements is true?

  1. Interest expense of $56,000 is recognized on January 1, Year Two.
  2. Interest payable of $56,000 is reduced on January 1, Year Two.
  3. No interest expense is reported for Year One because no interest was paid in that year.
  4. No interest liability is recorded at the end of Year One because payment is not due until Year Two.

Answer:

The correct answer is choice b: Interest payable of $56,000 is reduced on January 1, Year Two.

Explanation:

Interest was incurred throughout Year One on the borrowed funds and is recognized through a year-end adjusting entry. Both the interest expense and the interest payable for the period are reported in that way. On the following day, when payment is made, the liability is removed and cash is reduced. No additional interest expense is recognized on January 1, Year Two, because no time has yet passed since the interest was recognized at the end of Year One.

Issuance of Bonds between Interest Dates

Question: Bonds can be issued to a group of known investors or to the public in general. Often, companies will print bond indentures but not offer them to buyers until monetary levels run low. Thus, bonds are frequently issued on a day that falls between two interest dates. Payment must still be made to creditors as specified by the contract regardless of the length of time that the debt has been outstanding. If an interest payment is required, the debtor is legally obligated.

To illustrate, assume that the Brisbane Company plans to issue bonds with a face value of $400,000 to a consortium of twenty wealthy individuals. As in the previous example, these bonds pay a 6 percent annual interest rate with payments every May 1 and November 1. However, this transaction is not finalized until October 1, Year One, when Brisbane has need for the cash.

The first six-month interest payment must still be made on November 1 as stated in the contract. After just one month, the debtor is forced to pay interest for six months. That is not fair, and Brisbane would be foolish to agree to this arrangement. How does a company that issues a bond between interest payment dates ensure that the transaction is fair to both parties?

 

Answer: As indicated in this question, the issuance of a bond between interest dates is common. Thus, a standard system of aligning the first interest payment with the time that the debt has been outstanding is necessary. Because of the terms of the contract, Brisbane must pay interest for six months on November 1 even though the cash proceeds have been held for only one month. In this first payment, the creditor receives interest for an extra five months.

Consequently, such bonds are normally issued for a stated amount plus accrued interest. The accrued interest is measured from the previous interest payment date to the present and is charged to the buyer. Later, when the first payment is made, the net effect reflects just the time that the bond has been outstanding. If issued on October 1, Year One, the creditors should pay for the bonds plus five months of accrued interest. Later, when Brisbane makes the first required interest payment on November 1 for six months, the net effect is interest for one month—the period that has passed since the date of issuance (six months minus five months).

Assume that the creditors buy these bonds on October 1, Year One, for face value plus accrued interest. Because five months have passed since the previous interest date (May 1), interest on the bonds as of the issuance date is $10,000 ($400,000 × 6 percent × 5/12 year). Thus, the creditors pay $400,000 for the bond and an additional $10,000 for the interest that has accrued to that date. Once again, the actual recording can be made in more than one way but the entry presented in Figure 14.5 “Issuance of Bond on October 1 at Face Value plus Accrued Interest Recognized for Five Months” seems easiest.

Figure 14.5 Issuance of Bond on October 1 at Face Value plus Accrued Interest Recognized for Five Months

One month later, Brisbane makes the first interest payment of $12,000. However, interest expense of only $2,000 is actually recognized in the entry in Figure 14.6 “November 1, Year One—Payment of First Interest Payment”. That amount is the appropriate interest for the month of October ($400,000 × 6 percent × 1/12 year). This expense reflects the cost associated with the period that the bond has been outstanding. Interest of $10,000 for five months was collected initially by Brisbane. Interest of $12,000 was later paid by Brisbane for the entire six month period. Interest expense of $2,000 is the net result for that one month.

Figure 14.6 November 1, Year One—Payment of First Interest Payment

After this entry, the recording of interest follows the process demonstrated previously in Figure 14.3 “December 31, Year One—Accrual of Interest for Two Months” and Figure 14.4 “May 1, Year Two—Payment of Interest for Six Months”.

Test Yourself

Question:

On January 1, Year One, the Halenstein Corporation creates bond indentures with a total face value of $1.5 million that pay annual interest of 10 percent every December 31. The company had expected to sell the bonds on that date. However, the company’s monetary needs changed and the bonds were not issued until August 1. On that date they were sold for face value plus accrued interest. Thereafter, the bonds were serviced normally until their maturity on December 31, Year Four. Which of the following statements is true in connection with the Year One transactions?

  1. Halenstein receives $1,587,500 (August 1) and pays $150,000 (December 31).
  2. Halenstein receives $1,562,500 (August 1) and pays $150,000 (December 31).
  3. Halenstein receives $1,650,000 (August 1) and pays $62,500 (December 31).
  4. Halenstein receives $1,650,000 (August 1) and pays $87,500 (December 31).

Answer:

The correct answer is choice a: Halenstein receives $1,587,500 (August 1) and pays $150,000 (December 31).

Explanation:

Seven months pass before the bond is issued (January 1 to August 1). The interest that has accrued on this bond by that date is $87,500 ($1.5 million × 10 percent interest × 7/12 year). Thus, the buyers pay $1.5 million for the bond and $87,500 to cover the accrued interest. On the last day of the year, the contract calls for the payment of interest for a full year or $150,000 ($1.5 million face value × 10 percent stated interest rate).

Key Takeaway

Bond and note contracts include numerous terms that define the specific rights of both the debtor and the creditor. The face value of the debt and the payment patterns should be identified in these indentures as well as stated cash interest amounts and dates. Security agreements and other covenants are also commonly included to reduce the risk for potential creditors. For debts that are issued at face value, interest is recorded as paid and also at the end of each year to reflect any accrued amount. Bonds are frequently issued between interest dates so that an adjustment in the cash price must be made. Such debts are issued at a stated price plus accrued interest so that the agreement is fair to both parties. The journal entry at the time of the first payment then removes the amount recorded for this accrued interest.

14.3 Accounting for Zero-Coupon Bonds

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Identify the characteristics of a zero-coupon bond.
  2. Explain how interest is earned by a creditor on a zero-coupon bond.
  3. Understand the method of arriving at an effective interest rate for a bond.
  4. Calculate the price of a zero-coupon bond and list the variables that affect this computation.
  5. Prepare journal entries for a zero-coupon bond using the effective rate method.
  6. Explain the term “compounding.”
  7. Describe the theoretical problems associated with the straight-line method, and identify the situation in which this method can be applied.

The Issuance of a Zero-Coupon Bond

Question: A wide array of bonds and other types of financial instruments can be issued by parties (businesses and other organizations) seeking money. A zero-coupon bond is one that is popular because of its ease. The face value of a zero-coupon bond is paid to the creditor after a specified period of time, but no further cash is ever exchanged. Thus, no stated cash interest rate is paid. Money is received when the bond is issued and money is paid at the end of the term but no other payments are made. Why does any investor choose to purchase a zero-coupon bond if no interest is paid?

 

Answer: No investor would buy a note or bond that did not pay interest. That makes no economic sense. Because zero-coupon bonds are widely issued, some form of interest must be included.

These bonds are sold at a discount below face value with that reduction serving as interest. If a bond is issued for $37,000 and the company eventually repays its face value of $40,000, the $3,000 difference is the interest on the debt. That additional payment is the charge paid for the use of the money that was borrowed. The price reduction below face value can be so significant that zero-coupon bonds are sometimes referred to as deep discount bonds.

To illustrate, assume that on January 1, Year One, a company offers a $20,000 two-year zero-coupon bondA debt instrument that includes no interest payments; these bonds are issued at a discount with the difference between the cash received at the beginning and the cash paid on the maturity date serving as interest for that period of time. to the public. A single payment of $20,000 will be made to the holder of this bond on December 31, Year Two. According to the contract, no other cash will be paid. An investor who wishes to earn 7 percent annual interest can mathematically compute the exact amount to bid for this contract. The debtor must then decide whether to accept this offer.

Often, the actual exchange price for a bond is the result of a serious negotiation process to establish the interest rate to be earned. The potential creditor might initially offer an amount that equates to interest at an annual rate of 7 percent. The debtor could then counter by suggesting that an annual rate of 5 percent is more reasonable. After some discussion, the two parties might compromise by settling on a price that provides an annual interest rate of 6 percent. In the bond market, interest rates are the subject of intense negotiations. After the effective rateThe interest rate determined by negotiation and market forces that is used to set the price of a bond; it is also called the yield rate and often varies from the interest rate stated on the indenture that is used to establish cash interest payments. (also called the yield or negotiated rate) has been agreed on by both parties, the actual price of the bond is simply a mathematical computation.

Agreeing on a Price for a Bond

Question: A $20,000 zero-coupon bond is being issued by a company. According to the indenture, it comes due in exactly two years. The parties have negotiated an annual interest rate to be earned of 6 percent. How is the actual price to be paid for a bond mathematically determined after an effective rate of interest has been established?

 

Answer: Calculation of the price of a bond is based on the present value of the cash payments in the same manner as demonstrated previously in the coverage of intangible assets. Future cash payments are first identified and then valued by the mathematical removal of interest (the present value computation).

Here, a single cash payment of $20,000 is to be made by the debtor in two years. The parties have negotiated an annual 6 percent effective interest rate. Thus, a portion of the future cash ($20,000) serves as interest at an annual rate of 6 percent for this two-year period of time. In a present value computation, interest at the designated rate is calculated and subtracted to leave the principal amount of those payments. That is the price of the bond. Interest at a 6 percent annual rate for two years is removed. The remainder is the amount paid for the bond.

The present value of $1 in two years at an annual rate of interest of 6 percent is $0.8900. This can be found in a chart (through the link presented or in the tables at the end of this book), by formula, or by use of an Excel spreadsheet.As explained in the chapter on acquiring intangible assets, the present value of $1 can be mathematically determined using the formula $1/(1 + i)n. Here, i is 0.06 and n is two periods. Present value can also be determined using an Excel spreadsheet. If a spreadsheet is used, the present value of $1 at 6 percent in two periods is found by typing the following formula into a cell: =PV(.06,2,,1,0). Because the actual payment is $20,000 and not $1, the present value of the cash flows from this bond (its price) can be found as follows:

present value = future cash payment × $0.8900 present value = $20,000 × $0.8900 present value = $17,800

Bond prices are often stated as a percentage of face value. Thus, this bond is sold to the investor at “89” ($17,800/$20,000), which indicates that the price is 89 percent of the $20,000 face value. The price is the future cash payments with the negotiated rate of interest removed. If the investor pays $17,800 today and the debtor returns $20,000 in two years, the additional $2,200 is the interest. Mathematically, this extra $2,200 is equal to interest at 6 percent per year.

The issuance is recorded through the entry presented in Figure 14.8 “January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 6 Percent”.The entry shown in Figure 14.8 “January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 6 Percent” can also be recorded in a slightly different manner. Under this alternative, the liability is entered into the records at its face value of $20,000 along with a separate discount of $2,200. The discount serves as a contra account to reduce the net liability balance to its principal amount. Although visually different, the liability is still reported as $17,800.

Figure 14.6

 

Figure 14.8 January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 6 Percent

Test Yourself

Question:

On January 1, Year One, the Leisinger Company offers a ten-year zero-coupon bond with a face value of $80,000 to an investor. Leisinger hopes to issue this bond at an annual interest rate of 4 percent. The investor wants 7 percent and they finally agree on 5 percent. The present value of $1 at 4 percent annual interest for 10 years is $0.6756 and at 5 percent for ten years is $0.6139. The present value of an ordinary annuity of $1 for ten years at 4 percent annual interest is $8.1109 and at 5 percent is $7.7217. What amount does Leisinger Company receive (rounded)?

  1. $49,112
  2. $54,048
  3. $61,774
  4. $64,887

Answer:

The correct answer is choice a: $49,112.

Explanation:

The negotiated effective (or yield) interest rate is 5 percent per year. A single payment will be made in ten years. Using the rate for $1 (a single amount) in ten years at 5 percent interest per year, the present value is the cash of $80,000 times $0.6139 or $49,112. The present value factors have been mathematically determined to compute the appropriate interest which is then removed to leave the principal. At an annual rate of 5 percent, $49,112 will grow to be exactly $80,000 in ten years.

Recognizing Interest on a Zero-Coupon Bond

Question: The $20,000 zero-coupon bond discussed above is issued for $17,800 so that a 6 percent annual interest rate will be earned. As shown in Figure 14.8 “January 1, Year One—Zero-Coupon Bond Issued at Effective Annual Interest Rate of 6 Percent”, the bond is initially recorded at this principal amount.

Subsequently, two problems must be addressed by the accountant.

  • First, the company actually has to pay $20,000. Over time, the $17,800 principal balance must be raised to that face value. At the end of Year Two, the liability should be reported as $20,000.
  • Second, the $2,200 difference between the amount received and the eventual repayment ($20,000 less $17,800) has to be recognized as interest expense over these two years. The additional payment is the cost of the debt for this period, the interest.

To arrive at fairly presented figures, both of these problems must be resolved. How is a zero-coupon bond reported in the period after its issuance?

 

Answer: In the earlier discussion of present value and the purchase of assets (such as a patent), the effective rate method was demonstrated. It solves the two accounting problems mentioned here. The reported debt balance is raised gradually to the face value and interest expense equal to 6 percent is reported each year until maturity.

Interest recognized for Year One should be the $17,800 principal balance multiplied by the effective interest rate of 6 percent or $1,068. However, no cash interest payment is made for this zero-coupon bond. Thus, as is shown in Figure 14.9 “December 31, Year One—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and Compounded”, this interest is compounded—added to the principal of the debt. Interest that is recognized but not paid at that time is compounded, included in the balance of the liability.

Figure 14.9 December 31, Year One—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and CompoundedIf a discount is recorded in the initial entry, as is shown in endnote 6, the credit shown in Figure 14.9 “December 31, Year One—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and Compounded” is to the Discount account and not directly to the bond payable. Because the contra account is reduced, the net liability balance increases by $1,068. Thus, overall reporting of the interest and the liability is not impacted by the method used in recording the issuance of the bond.

The compounding of this interest raises the principal by $1,068 from $17,800 to $18,868. The balances to be reported in the financial statements at the end of Year One are as follows:

Year One—Interest Expense (Income Statement) $1,068
December 31, Year One—Bond Payable (Balance Sheet) $18,868

The principal is higher in Year Two because of the compounding (addition) of the first year interest. As the principal increases, interest for subsequent periods must also go up. As reflected in Figure 14.10 “December 31, Year Two—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and Compounded”, interest for Year Two is 6 percent of the new liability balance of $18,868 or $1,132 (rounded).

Figure 14.10 December 31, Year Two—Interest on Zero-Coupon Bond at 6 Percent Rate Is Recognized and Compounded

Note that the bond payable balance has now been raised to $20,000 as of the date of payment ($17,800 + $1,068 + $1,132). In addition, interest expense of $2,200 ($1,068 + $1,132) has been recognized over the two years. Reported interest was exactly 6 percent of the principal in each year. Total interest reported for this zero-coupon bond is equal to the difference between the amount received by the debtor and the face value eventually repaid. Both of the accounting problems have been resolved through the application of the effective rate method.

The $17,800 price of the bond was computed mathematically based on the following:

  • The cash payment ($20,000)
  • The time periods (two)
  • The effective rate of interest (the 6 percent negotiated rate)
  • The pattern of cash flows (a single payment in the future)

Interest is then recognized each period based on this same set of variables. Thus, the resulting numbers will reconcile. Interest expense reported for the two years is $2,200 and the final liability balance comes back to $20,000.

Test Yourself

Question:

The O’Neil Company issues a six-year $40,000 zero-coupon bond on January 1, Year One. At that time, most companies are able to borrow money at an annual rate of 10 percent. O’Neil is in such good financial health that the bond is sold for $25,207 to yield a negotiated rate of 8 percent per year. What is reported in O’Neil’s financial statements at the end of Year One if the effective rate method is applied? (All numbers are rounded.)

  1. Interest expense of $2,017 and a bond payable of $27,224.
  2. Interest expense of $2,112 and a bond payable of $27,319.
  3. Interest expense of $2,215 and a bond payable of $27,422.
  4. Interest expense of $2,521 and a bond payable of $27,728.

Answer:

The correct answer is choice a: Interest expense of $2,017 and a bond payable of $27,224.

Explanation:

Interest to be reported for the first year is the 8 percent negotiated rate times the principal of $25,207 or $2,017 (rounded). This is a zero-coupon bond so no interest is paid as time passes. Because no cash interest is actually paid, this entire amount of interest for the first year is compounded to raise the principal by $2,017 from $25,207 to $27,224. In this manner, the principal balance should reach $40,000 after six years.

Test Yourself

Question:

Johnson Company issues an eight-year $50,000 zero-coupon bond on January 1, Year One. After serious negotiations between the company and the investor, this bond is sold for $31,371 to yield an effective annual rate of 6 percent. What is reported in Johnson’s financial statements at the end of Year Two if the effective rate method is applied? (All numbers are rounded.)

  1. Interest expense of $1,882 and a bond payable of $33,253.
  2. Interest expense of $1,882 and a bond payable of $35,135.
  3. Interest expense of $1,995 and a bond payable of $35,248.
  4. Interest expense of $2,015 and a bond payable of $35,285.

Answer:

The correct answer is choice c: Interest expense of $1,995 and a bond payable of $35,248.

Explanation:

Interest for the first year is the $31,371 principal times the effective annual rate of 6 percent or $1,882. As a zero-coupon bond, no interest is paid. The entire $1,882 is compounded by adding it to the principal so that the balance is $33,253. For Year Two, interest expense is now recognized as $1,995 or 6 percent times the updated principal of $33,253. Again, the interest is compounded so the liability is reported at $35,248. In this manner, the balance will be $50,000 after 8 years.

Recognizing Interest Using the Straight-Line Method

Question: The previous zero-coupon bond was sold at the present value of its future cash flows based on a rate of interest negotiated by the parties involved. Interest was then recognized each year by applying the effective rate method. Is the effective rate method the only acceptable technique that can be used to compute and report interest when the face value of a debt differs from its issue price?

 

Answer: When a zero-coupon bond is issued at a discount, interest to be reported each year can also be calculated by a simpler approach known as the straight-line method. According to this technique, an equal amount of the discount is assigned to interest each period over the life of the bond. This zero-coupon bond was issued for $2,200 below face value to provide interest to the buyer. Payment of the face value will be made in two years. As is shown in Figure 14.11 “December 31, Years One and Two—Interest on Zero-Coupon Bond at 6 Percent Rate—Straight-Line Method”, the straight-line method recognizes interest of $1,100 annually ($2,200/2 years).

Figure 14.11 December 31, Years One and Two—Interest on Zero-Coupon Bond at 6 Percent Rate—Straight-Line Method

Once again, the bond payable balance has been raised to $20,000 by the end of the second year ($17,800 + $1,100 + $1,100) and total interest expense over the life of the bond equals the $2,200 discount ($1,100 + $1,100). However, a theoretical question should be raised as to whether the information reported under this method is a fairly presented portrait of the events that took place. Although the bond was sold to earn 6 percent annual interest, this rate is not reported for either period.

Year One: $1,100 interest/$17,800 principal = 6.2 percent

Compounding of the interest raises the principal by $1,100 to $18,900

Year Two: $1,100 interest/$18,900 principal = 5.8 percent

The debtor and creditor agreed on an annual rate of exactly 6 percent for the entire two-year period. When applying the straight-line method, this rate is not reported for either year. Furthermore, the interest rate appears to float (6.2 percent to 5.8 percent) as if a different rate was negotiated for each year. That change does not reflect reality. A single 6 percent annual interest rate was established by these two parties.

Although the straight-line method creates some theoretical concerns, it can still be applied according to U.S. GAAP but only if the reported results are not materially different from those derived using the effective rate method.

Test Yourself

Question:

The Reynolda Company issues an eight-year $80,000 zero-coupon bond on January 1, Year One. After serious negotiations, this bond is sold for $54,144 to yield an effective annual rate of 5 percent. What is reported in Reynolda’s financial statements at the end of Year Two if the straight-line method is applied to this discount? (All numbers are rounded.)

  1. Interest expense of $3,198 and a bond payable of $60,540.
  2. Interest expense of $3,232 and a bond payable of $60,608.
  3. Interest expense of $3,268 and a bond payable of $60,680.
  4. Interest expense of $3,304 and a bond payable of $60,752.

Answer:

The correct answer is choice b: Interest expense of $3,232 and a bond payable of $60,608.

Explanation:

This bond was sold at a discount of $25,856 ($80,000 less $54,144) to provide interest over the eight-year life of this bond. If the straight-line method is used, this discount is allocated equally to interest each period. That annual amount is $3,232 ($25,856/8 years). No cash interest is being paid during the life of this bond. Thus, the recognized interest each period is compounded to arrive at a principal balance of $60,608 after two years ($54,144 plus $3,232 plus $3,232).

Key Takeaway

Zero-coupon bonds pay no explicitly-stated cash interest. Instead, they are issued at a discount with the difference between the price and face value serving as interest. The price of the bond is determined by computing the present value of the required cash flows based on the effective interest rate negotiated by the two parties. The present value figure represents the principal of the debt with all future interest mathematically removed. The bond is issued for this amount. Interest is subsequently determined each period using the effective (or yield) rate. Because no interest is paid, the entire amount recognized must be compounded (added) to the principal. The straight-line method can also be used to record interest if the resulting numbers are not materially different from the effective rate method. This alternative assigns an equal amount of the discount to interest each period over the bond’s life.

14.4 Pricing and Reporting Term Bonds

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Understand the difference between a stated cash interest rate in a debt contract and an effective interest rate negotiated by the debtor and creditor.
  2. Compute the price of a term bond when the stated cash interest rate is different from the effective interest rate.
  3. Determine the amount of interest to be compounded each period when the stated cash interest rate specified on a bond contract is different from the effective interest rate established by the parties.
  4. Prepare all journal entries for a term bond when the stated cash interest rate is different from the effective interest rate.

Determining the Price of a Term Bond

Question: Although zero-coupon bonds are popular, most bonds actually do pay a stated rate of cash interest, one that is specified in the contract. If the buyer and seller negotiate an effective rate of interest that is the same as this stated rate, an amount equal to face value is paid for the bond. For example, if the stated interest is 7 percent per year and a negotiated annual rate of 7 percent is accepted by the parties, the bond is issued at its face value. No discount or premium results; the debtor and creditor are both satisfied with the interest being paid. The effective rate method is not needed because the cash interest and the effective interest are the same—7 percent is paid each period and recognized as interest.

However, the negotiated rate often differs from the cash rate stated in the bond contract. Market interest rate conditions change quickly. The interest that creditors demand will often shift between the printing of the indenture and the actual issuance day. Or the financial reputation of the company might move up or down during this time. Information travels so quickly in this technology age that news about companies—both good and bad—spreads rapidly.

To illustrate, assume that Smith Corporation decides to issue $1 million in term bonds to the public on January 1, Year One. The face value of these bonds comes due in four years. During the interim, annual interest at a stated rate of 5 percent will be paid starting on December 31, Year One.

No investors can be found who want to purchase Smith Corporation bonds with only a 5 percent annual return. Therefore, in setting an issuance price, annual interest of 6 percent is negotiated. Possibly, interest offered by other similar companies is 6 percent so that Smith had to match this rate to entice investors to buy its bonds. Or some recent event has made Smith seem slightly more risky causing potential creditors to demand a higher rate of return. A list of market conditions that can impact the price of a bond would be almost unlimited. How is the price of a bond calculated when the stated cash interest rate differs from the effective rate negotiated by the two parties involved?

 

Answer: The pricing of a bond always begins by identifying the cash flows specified by the contract. These amounts are set and will not be affected by the eventual sales price. The debtor is legally obligated to make these payments regardless of whether the bond is sold for $1 or $10 million.

Here, Smith Corporation must pay $50,000 per year in interest ($1 million × 5 percent) for four years and then the $1 million face value:

Future Cash Flows Set by Bond Contract
$50,000 annually for four years (5 percent stated rate)
$1,000,000 in four years (face value of term bond)

After the cash flows are identified, the present value of each is calculated based on the negotiated yield rate. These two present values are then summed to arrive at the price to be paid for the bond. The $50,000 annual interest payments form an annuity—equal amounts are paid at equal time intervals. Because interest is paid at the end of each period starting on December 31, Year One, these payments constitute an ordinary annuity.As mentioned in earlier discussions about the acquisition of intangible assets, an annuity with payments made at the beginning of each period is known as an annuity due. If the interest had been paid starting on January 1, Year One, the payments here would form an annuity due rather than an ordinary annuity. The cash flow pattern for notes and bonds is more likely to be in the form of an ordinary annuity since interest is not typically paid in advance.

As determined by table, formula, or Excel spreadsheet, the present value of an ordinary annuity of $1 at an effective annual interest rate of 6 percent over four years is $3.46511.The mathematical formula to determine the present value of an ordinary annuity of $1 is (1 – 1/[1 + i]n)/i, where i is the appropriate interest rate (6 percent in this illustration) and n is the number of payment periods (four). If using an Excel spreadsheet, the present value of a $1 per period ordinary annuity for four periods at an annual rate of interest of 6 percent can be found by typing the following data into a cell: =PV(.06,4,1,,0). Thus, the present value of the four interest payments is $50,000 times $3.46511 or $173,256 (rounded). Note that the present value computation requires the multiplication of one annuity payment ($50,000) rather than the total amount of all interest payments ($200,000).

The second part of the cash flows promised by this bond is a single payment of $1 million in four years. The present value of a payment of $1 in four years at a 6 percent annual rate is $0.79209 so the present value of the entire $1 million is $792,090.

Based on an annual interest rate of 6 percent for four years, the present value of the cash flows required by this term bond contract is $173,256 (cash interest) plus $792,090 (face value) or a total of $965,346. Smith receives this amount on January 1, Year One, but must pay back $50,000 per year for four years followed by a single payment of $1 million. Mathematically, that is equivalent to a 6 percent rate of interest each year for four years. The journal entry to record the issuance is shown in Figure 14.12 “January 1, Year One—Term Bonds Issued at an Effective Rate of 6 Percent”.

Figure 14.12 January 1, Year One—Term Bonds Issued at an Effective Rate of 6 Percent

Test Yourself

Question:

The Venture Company issues a twenty-year bond with a face value of $500,000 on January 1, Year One. According to the bond contract, cash interest at a stated rate of 2 percent will be paid each year beginning on December 31, Year One. The Manhattan Investment Company wants to buy this bond but demands an effective annual interest rate of 9 percent. After some discussion, both parties agree that the bond will be sold to earn an annual interest rate of 8 percent. The present value of $1 in twenty years at a rate of 8 percent is $0.21455. The present value of an ordinary annuity of $1 per year for twenty years at a rate of 8 percent per year is $9.81815. The present value of an annuity due of $1 per year for twenty years at a rate of 8 percent per year is $10.60360. How much does Manhattan Investment Company pay the Venture Company for this bond (rounded)?

  1. $205,457
  2. $209,145
  3. $213,311
  4. $217,445

Answer:

The correct answer is choice a: $205,457.

Explanation:

Cash interest of $10,000 is paid annually for twenty years ($500,000 × 2 percent). This is an ordinary annuity, since payments are made at each year’s end. A single payment of $500,000 is also due in twenty years. Present value of the interest is $10,000 times $9.81815, or $98,182. Present value of the face value is $500,000 times $0.21455, or $107,275. Total present value is $205,457. That amount is offered by the creditor and accepted by the debtor because it equals 8 percent per year.

Calculating Interest When a Term Bond Is Issued at a Discount

Question: After the previously described term bond was issued at a discount, the debtor has the same two accounting problems that were discussed previously for zero-coupon bonds.

How does a debtor report a bond payable over its life if the stated cash interest rate and the effective rate differ?

 

Answer: At the end of Year One, Smith Corporation pays $50,000 cash interest to the bondholders as specified in the contract ($1 million face value × 5 percent annual stated rate). However, interest expense must be reported on the income statement based on the agreed upon rate of 6 percent. That was the negotiated rate that led to the initial payment of $965,346. This discounted price was accepted by Smith (the debtor) as a means of increasing the actual rate of return from 5 percent per year to 6 percent.

The effective rate is reflected in the financial statements by recognizing interest in Year One of $57,921 (rounded), which is the $965,346 principal balance times 6 percent. The $7,921 difference between the effective interest expense of $57,921 and the cash interest payment of $50,000 will eventually be paid at the end of the four-year term when $1 million rather than $965,346 is conveyed to the bondholders. Therefore, at the current time, this extra $7,921 is compounded (increasing the liability balance). Note that only the portion of this interest that is not paid is added to the principal. Earlier, with the zero-coupon bond, the entire amount of interest each year was compounded, but that was because no cash interest payment was made.

The cash interest payment is recorded in Figure 14.13 “December 31, Year One—Payment of Cash Interest at 5 Percent Rate” with the compounding entry shown in Figure 14.14 “December 31, Year One—Compounding Entry to Adjust Interest to Effective Annual Rate of 6 Percent”. These two entries can be recorded separately or combined.

Figure 14.13 December 31, Year One—Payment of Cash Interest at 5 Percent Rate

Figure 14.14 December 31, Year One—Compounding Entry to Adjust Interest to Effective Annual Rate of 6 Percent

The interest expense reported on the income statement for Year One of $57,921 ($50,000 + $7,921) equals the 6 percent effective rate times the principal of the debt for that period. The liability on the balance sheet at the end of Year One has begun to move closer to the $1 million face value. The reported figure is now $973,267 ($965,346 + $7,921) as a result of the compounding.

As shown in Figure 14.15 “Reported Bond Figures for Remaining Three Years until Maturity”, reported figures for the remaining three years of this bond contract can be calculated to verify that the ending balance does grow to $1 million by the time of payment.

Figure 14.15 Reported Bond Figures for Remaining Three Years until MaturityInterest expense for the final year has been increased by $3 so that the final bond payable balance is exactly equal to the $1 million debt that must be paid. Slight adjustments of this type are common to compensate for numbers having been rounded.

Through the use of the effective rate method, interest expense of 6 percent is recognized each period and the principal balance reported for the liability does gradually grow to equal the face value of the bond on the maturity date.

Test Yourself

Question:

On June 30, Year One, a company issues ten-year term bonds with a total face value of $600,000. Only interest at a 4 percent annual rate is paid each June 30 and December 31 beginning at the end of Year One. These bonds were issued for $375,680 to earn a negotiated rate of 10 percent per year over the ten-year term. What does the company report on its December 31, Year One, balance sheet for this liability?

  1. $380,775
  2. $381,225
  3. $382,464
  4. $383,646

Answer:

The correct answer is choice c: $382,464.

Explanation:

After six months, the company pays interest to the creditors of $12,000 ($600,000 × 4% × 1/2 year). Interest for the same period—based on an annual yield rate of 10 percent—is $18,784 ($375,680 × 10% × 1/2). The extra interest recognized over the amount paid ($6,784 or $18,784 less $12,000) is compounded to begin moving the principal to the $600,000 face value. At the end of Year One, the bond payable has been raised to $382,464, the original principal of $375,680 plus the compound interest of $6,784.

Key Takeaway

The stated cash interest rate for a term bond is often different from the effective interest rate negotiated between the creditor and the debtor. To compute the amount of money to be exchanged for the bond, the cash flows are determined based on the terms of the contract. The present value of these payments is then calculated. The resulting total is the amount initially paid so that the agreed upon rate of interest is earned over the life of the bond. Cash interest payments are conveyed thereafter with the interest balance adjusted each period based on the effective rate. The interest rate stated in the contract times the face value provides the amount of each cash payment. The principal of the debt times the effective rate gives the interest expense to be recognized for the period. The difference in the effective interest and the cash payment is compounded (added to the principal of the debt). On the maturity date, the liability balance should be equal to the face value of the debt instrument.

14.5 Issuing and Accounting for Serial Bonds

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Define a serial bond.
  2. Identify the steps to calculate the price of a serial bond and provide the proper accounting for the issuance.
  3. Record the interest and payments on a serial bond over its life.
  4. Explain the determination of interest expense for a serial bond and the amount that must be compounded each period.

Recording the Issuance of a Serial Bond

Question: The previous section examined the recording of term bonds. Interest was paid each period but no payment was made on the face value until the maturity date. How do these procedures differ for a serial bond where both interest and a portion of the face value are paid periodically?

To demonstrate this process, assume that Smith Corporation issues a four-year, $1 million serial bond on January 1, Year One. This bond will pay a 5 percent stated interest rate at the end of each year on the unpaid face value for the period. The indenture further specifies that $250,000 of the face value is to be paid annually at the same time as the interest. Smith officials negotiate with potential investors and finally agree on a 6 percent annual effective rate. What accounting is appropriate for a serial bond?

 

Answer: From the previous coverage, the reporting of a term bond where the stated cash interest and the effective rate are different can be divided into five steps:

  1. The cash flows required by the bond contract are identified.
  2. The total present value of these cash flows is determined using the effective rate of interest negotiated by the parties. Present value mathematically removes all future interest at the appropriate rate leaving only the principal of the debt. Thus, this resulting figure is the exact amount to be paid so that the agreed-upon interest rate is earned over the life of the bond.
  3. The bond is recorded at the principal (present value) amount paid by the investors.
  4. The debtor pays the stated rate of interest periodically on the dates indicated in the contract.
  5. The effective rate method is applied. Interest to be reported for each period is determined by multiplying the liability’s principal balance times the effective interest rate. The cash interest figure is adjusted to this calculated amount with the difference compounded (added to the principal).The series of steps shown here is also used when a bond is issued at a premium above face value. If the effective interest rate negotiated by the parties is below the stated cash rate, the amount paid for the bond (the present value) will be above face value rather than below. In effect, the high rate of cash interest makes the bond more valuable. Thereafter, the effective interest recognized each period will be below the cash interest. Adjustment is made to lower the cash interest rate to the effective rate, which also reduces the reported principal balance moving it toward face value. Thus, when the negotiated rate is below the stated cash rate, a premium is created rather than a discount. The subsequent accounting process is not affected except that the increases and decreases are reversed from the examples shown here for a discount.

This same process is applied when a serial bond is issued. The sole difference is that regular payments are also made to reduce the face value of the debt over time. To account for the Smith Corporation serial bond described above, the following five steps are required.

Identify cash flows specified in the bond contract. As shown in Figure 14.16 “Cash Payments Required by Serial Bond Contract”, Smith is required to make an annual $250,000 payment to reduce the face value of this serial bond. In addition, interest must be paid each year. During Year One, the unpaid face value is the original $1 million. The stated rate is 5 percent necessitating a $50,000 year-end interest payment ($1,000,000 × 5 percent).

Following the $250,000 payment on December 31, Year One, the face value of the bond drops to $750,000 throughout the second year. Consequently, the interest payment at the end of Year Two is only $37,500 ($750,000 × 5 percent). As a serial bond, the annual payments cause the face value to get smaller so that the interest payments are less each year.

Based on the terms of the contract, the cash flows required by this bond are identified in Figure 14.16 “Cash Payments Required by Serial Bond Contract”.

Figure 14.16 Cash Payments Required by Serial Bond Contract

Determine present value of the cash flows. These required cash flows can be organized in either of two ways.

The same cash flows are described in both cases. Thus, as proven by a comparison of Figure 14.17 “Computation of Present Value of Serial Bond—First Pattern of Cash Flows” and Figure 14.18 “Computation of Present Value of Serial Bond—Second Pattern of Cash Flows”, the resulting present value will be identical ($977,714) regardless of the approach that is followed. A link to the tables for the present value of an ordinary annuity of $1 and the present value of $1 are provided here but those tables are also included at the end of this textbook.

Figure 14.17 Computation of Present Value of Serial Bond—First Pattern of Cash Flows

Figure 14.18 Computation of Present Value of Serial Bond—Second Pattern of Cash Flows

Record the principal amount received in the issuance of the bond. Based on either of these computations, $977,714 in cash is exchanged for this four-year $1 million serial bond with an annual stated rate of 5 percent. That payment amount creates an effective rate of interest of 6 percent per year. The issuance of the bond is recorded through the journal entry shown in Figure 14.19 “January 1, Year One—Issuance of $1 Million Serial Bonds Paying 5 Percent Annual Interest with an Effective Rate of 6 Percent”.

Figure 14.19 January 1, Year One—Issuance of $1 Million Serial Bonds Paying 5 Percent Annual Interest with an Effective Rate of 6 Percent

Payment of stated cash interest at 5 percent annual rate. Because of the terms specified in the bond contract, interest of $50,000 will be paid at the end of Year One, $37,500 at the end of Year Two, and so on. The Year One interest payment is recorded in Figure 14.20 “December 31, Year One—Payment of 5 Percent Interest on Serial Bond”. To better illustrate the handling of interest in a serial bond, the $250,000 payments on the face value are shown separately in Figure 14.22 “December 31, Year One—Payment on Face Value of Serial Bond”.

Figure 14.20 December 31, Year One—Payment of 5 Percent Interest on Serial Bond

Effective rate method is applied to recognize the interest rate that was negotiated by the two parties. For the first year, the principal balance of this debt is the original issuance price of $977,714. The yield rate agreed on by the two parties was 6 percent. Thus, the interest to be recognized for Year One is $58,663 ($977,714 × 6 percent).

As shown in Figure 14.20 “December 31, Year One—Payment of 5 Percent Interest on Serial Bond”, the cash interest paid is only 5 percent of the face value or $50,000. The $8,663 in extra interest for the period ($58,663 less $50,000) is compounded—added to the principal of the bond payable. The interest to be compounded is added to the principal in Figure 14.21 “December 31, Year One—Adjustment of Interest from Cash Rate to Effective Rate”.

The journal entries shown in Figure 14.20 “December 31, Year One—Payment of 5 Percent Interest on Serial Bond” and Figure 14.21 “December 31, Year One—Adjustment of Interest from Cash Rate to Effective Rate” are often combined in practice. They are separated here for discussion purposes.

Figure 14.21 December 31, Year One—Adjustment of Interest from Cash Rate to Effective Rate

In addition, as a serial bond, the first payment of the face value is made at the end of Year One and shown in Figure 14.22 “December 31, Year One—Payment on Face Value of Serial Bond”.

Figure 14.22 December 31, Year One—Payment on Face Value of Serial Bond

Whether a long-term liability is a term bond or a serial bond, the accounting process is the same. It follows the five steps that have been listed above and demonstrated here. All the amounts to be recorded over the four-year life of this bond can be computed to verify that the final payment does appropriately remove the remainder of the debt. Those figures are presented in Figure 14.23 “Balances to be Reported Over the Four-year Life of Serial Bond”.

Figure 14.23 Balances to be Reported Over the Four-year Life of Serial BondThe interest recognized in the final year has been adjusted by $3 to compensate for the rounding of several computations so that the liability balance drops precisely to zero at the end of the four years.

Test Yourself

Question:

The Heyman Company issues a $500,000 serial bond on January 1, Year One. At the end of each year, the bond pays $100,000 of the face value plus interest at a 4 percent rate on the unpaid balance for the period. The bond was sold at an effective yield rate of 5 percent per year. The present value of $1 at a 5 percent annual rate in one year is $0.95238, in two years is $0.90703, in three years is $0.86384, in four years is $0.82270, and in five years is $0.78353. The present value of an ordinary annuity at a 5 percent annual rate for five years is $4.32948. What amount did Heyman Company receive when the bond was issued (rounded)?

  1. $483,865
  2. $486,590
  3. $490,130
  4. $492,545

Answer:

The correct answer is choice b: $486,590.

Explanation:

As a serial bond, cash payments of $100,000 are made each year. In addition, interest payments for each year are as follows.

By combining the face value payments with the interest, the present value at an annual rate of 5 percent can be calculated.

Test Yourself

Question:

The Mullins Company issues a $500,000 serial bond on January 1, Year One. At the end of each year, the bond pays $100,000 of the face value plus interest at a 3 percent rate on the unpaid balance for the period. The bond was sold for $473,200 to yield an effective rate of 5 percent per year. What will Mullins report for this bond on its December 31, Year Two, balance sheet?

  1. $288,953
  2. $292,875
  3. $295,445
  4. $297,905

Answer:

The correct answer is choice a: $288,953.

Explanation:

Effective interest for Year One is $473,200 × the yield rate of 5 percent or $23,660. Because only $15,000 ($500,000 times 3 percent) is paid, the extra $8,660 is compounded. The $473,200 goes up by this $8,660 but down by the $100,000 payment to $381,860. Interest for Year Two is $19,093 ($381,860 × 5 percent). Only $12,000 ($400,000 × 3 percent) is paid so the $7,093 difference is compounded. The $381,860 plus $7,093 but less the next $100,000 payment leaves a balance of $288,953.

Key Takeaway

The issuance price for bonds (whether serial bonds or term bonds) can be computed and the subsequent accounting outlined in five general steps: (1) determine the cash payments required by the bond contract, (2) calculate the present value of those cash flows based on the negotiated effective rate of interest, a computation that sets the price to be paid for the bond, (3) record the bond at this exchange price (the present value amount), (4) over time, record each periodic cash interest payment, and (5) adjust the stated cash interest amounts to the effective interest rate through a compounding entry. A serial bond extends this process slightly because a portion of the face value is also paid periodically. The debt principal goes up each year as a result of interest compounding. However, in recording a serial bond, the principal also goes down because of the periodic payments of the face value.

14.6 Bonds with Other Than Annual Interest Payments

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Realize that cash interest payments are often made more frequently than once a year, such as each quarter or semiannually.
  2. Determine the stated interest rate, the effective interest rate, and the number of time periods to be used in a present value computation when interest payments cover a period of time of less than a year.
  3. Compute the stated cash interest payments and the effective interest rate when interest is paid on a bond more frequently than once each year.
  4. Prepare journal entries for a bond when the interest payments are made for a period of time shorter than a year.

Question: In the previous examples, both the interest rates and payments always covered a full year. How is this process affected if interest payments are made at other time intervals such as each quarter or semiannually?

As an illustration, assume that on January 1, Year One, an entity issues term bonds with a face value of $500,000 that will come due in six years. Cash interest payments at a 6 percent annual rate are required by the contract. However, the actual disbursements are made every six months on June 30 and December 31. In setting a price for these bonds, the debtor and the creditor negotiate an effective interest rate of 8 percent per year. How is the price of a bond determined and the debt reported if interest payments occur more often than once each year?

 

Answer: None of the five basic steps for issuing and reporting a bond is affected by a change in the frequency of interest payments. However, both the stated cash rate and the effective rate must be set to agree with the time interval between payment dates. The number of time periods used in the present value computation also varies based on the time that passes from one payment to the next.

In this current example, interest is paid semiannually, so each time period is only six months in length. The stated cash interest rate to be paid during that period is 3 percent or 6/12 of the annual 6 percent rate listed in the bond contract. Similarly, the effective interest rate is 4 percent or 6/12 of the annual 8 percent negotiated rate. Both of these interest rates must align with the specific amount of time between payments. Over the six years until maturity, the bond is outstanding for twelve of these six-month periods of time.

Thus, for this bond, the cash flows will be the interest payments followed by settlement of the face value.

  • Interest Payments: $500,000 face value times 3 percent stated rate for a $15,000 interest payment every six months during these twelve periods. Equal payments are made at equal time intervals making this an annuity. Because payments are made at the end of each period, these payments constitute an ordinary annuity.
  • Face value: $500,000 is paid at the end of these same twelve periods. This cash payment is a single amount.

As indicated, the effective rate to be used in determining the present value of these cash payments is 4 percent per period or 6/12 times 8 percent.

  • The present value of $1 in twelve periods at an effective rate of 4 percent per period is $0.62460.
  • The present value of an ordinary annuity of $1 for twelve periods at an effective rate of 4 percent per period is $9.38507.
  • The present value of the face value cash payment is $500,000 times $0.62460 or $312,300.
  • The present value of the cash interest payments every six months is $15,000 times $9.38507 or $140,776 (rounded).
  • The total present value of the cash flows established by this contract is $312,300 plus $140,776 or $453,076. As shown in Figure 14.24 “January 1, Year One—Issuance of $500,000 Bond with a 3 Percent Stated Rate to Yield Effective Rate of 4 Percent Semiannually”, the bond is issued for this present value amount. With this payment, the agreed-upon effective rate of interest (8 percent for a full year or 4 percent for each six-month period) will be earned by the investor over the entire life of the bond.

Figure 14.24 January 1, Year One—Issuance of $500,000 Bond with a 3 Percent Stated Rate to Yield Effective Rate of 4 Percent Semiannually

On June 30, Year One, the first $15,000 interest payment is made as reported in Figure 14.25 “June 30, Year One—Cash Interest Paid on Bond for Six-Month Period”. However, the effective interest rate for that period is the principal of $453,076 times the six-month negotiated rate of 4 percent or $18,123 (rounded). Therefore, the interest to be compounded for this first six-month period is $3,123 ($18,123 interest less $15,000 payment). That is the amount of interest recognized but not yet paid that is added to the liability as shown in Figure 14.26 “June 30, Year One—Interest on Bond Adjusted to Effective Rate”.

Figure 14.25 June 30, Year One—Cash Interest Paid on Bond for Six-Month Period

Figure 14.26 June 30, Year One—Interest on Bond Adjusted to Effective Rate

The compound interest recorded previously raises the bond’s principal to $456,199 ($453,076 principal plus $3,123 in compound interest). The principal is gradually moving to the $500,000 face value. Another $15,000 in cash interest is paid on December 31, Year One (Figure 14.27 “December 31, Year One—Cash Interest Paid on Bond for Six-Month Period”). The effective interest for this second six-month period is $18,248 (rounded) or $456,199 times 4 percent interest. The compound interest recognized on December 31, Year One, is $3,248 ($18,248 less $15,000), a balance that is recognized by the entry presented in Figure 14.28 “December 31, Year One—Interest on Bond Adjusted to Effective Rate”.

Figure 14.27 December 31, Year One—Cash Interest Paid on Bond for Six-Month Period

Figure 14.28 December 31, Year One—Interest on Bond Adjusted to Effective Rate

The Year One income statement will report interest expense of $18,123 for the first six months and $18,248 for the second, giving a total for that year of $36,371. The second amount is larger than the first because of compounding.

The December 31, Year One, balance sheet reports the bond payable as a noncurrent liability of $459,447. That is the original principal (present value) of $453,076 plus compound interest of $3,123 (first six months) and $3,248 (second six months). Once again, interest each period has been adjusted from the cash rate stated in the bond contract to the effective rate negotiated by the two parties. Here, the annual rates had to be halved because payments were made semiannually.

Test Yourself

Question:

Friday Corporation issues a two-year bond on January 1, Year One, with a $300,000 face value and a stated annual cash rate of 8 percent. The bond was sold to earn an effective annual rate of 12 percent. Interest payments are made quarterly beginning on April 1, Year One. The present value of $1 at a 3 percent rate in eight periods is $0.78941. The present value of $1 at a 12 percent rate in two periods is $0.79719. The present value of an ordinary annuity of $1 at a 3 percent rate for eight periods is $7.01969. The present value of an ordinary annuity of $1 at a 12 percent rate for two periods is $1.69005. What amount will Friday receive for this bond?

  1. $276,055
  2. $278,941
  3. $284,785
  4. $285,179

Answer:

The correct answer is choice b: $278,941.

Explanation:

This bond pays interest of $6,000 every three months ($300,000 × 8 percent × 3/12) and $300,000 in two years. Based on quarterly payments, effective interest is 3 percent (12 percent × 3/12 year) and cash flows are for eight periods (every three months for two years). Present value of the interest is $6,000 × $7.01969, or $42,118. Present value of the face value is $300,000 × $0.78941, or $236,823. Total present value (price of the bond) is $42,118 + $236,823, or $278,941.

Key Takeaway

Bonds often pay interest more frequently than once a year—for example, at an interval such as every three months or six months. If the stated cash rate and the effective rate differ, determination of present value is still required to arrive at the principal amount to be paid when the bond is issued. However, the present value computation must be adjusted to reflect the change in the length of a time period. The amount of time between payments is considered one period. The stated cash interest rate, the effective rate negotiated by the parties, and the number of time periods until maturity are all set for that particular time. The actual accounting and reporting are not affected, merely the method by which the interest rates and the number of periods are calculated.

Talking With a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: Assume that you are investigating two similar companies. You are thinking about recommending one of them to your clients as an investment possibility. The financial statements look much the same except that one of these companies has an especially low amount of noncurrent liabilities whereas the other has a noncurrent liability total that seems quite high. How does that difference impact your thinking? Long-term liabilities are a great way to gain financing because a company can make use of someone else’s money. However, debt does increase risk.

Kevin Burns: I have managed to do well now for many years by being a conservative investor. My preference is always for the company that is debt free or as close to debt free as possible. I do not like financial leverage, never have. I even paid off my own home mortgage more than ten years ago.

On the other hand, long-term liabilities have to be analyzed as they are so very common. Is any of the debt convertible into capital stock so that it could potentially dilute everyone’s ownership in the company? Is the company forced to pay a high rate of interest? Why was the debt issued? In other words, how did the company use all that cash that it received? As with virtually every area of financial reporting, you have to look behind the numbers to see what is actually happening. That is why transparency is important. If the debt was issued at a low interest rate in order to make a smart acquisition, I am impressed. If the debt has a high rate of interest and the money was not well used, that is not attractive to me at all.

14.7 End-of-Chapter Exercises

Questions

  1. The Lohr Company needs $40 million in cash to expand several of its facilities. Company officials chose to issue bonds to raise this money rather than capital stock. What are some of the possible reasons for this decision?
  2. Officials for the Bohannon Corporation have always avoided incurring noncurrent liabilities as a company policy. Over the years, they have raised long-term financing through operations or from the issuance of capital stock. Why might these officials have preferred that money be raised by means other than noncurrent liabilities?
  3. The president of the Nelson Company is a fan of financial leverage. He wants to expand operations into California and Oregon and borrows $70 million on 8 percent term bonds to finance this decision. How does he hope to make financial leveraging work for the Nelson Company in this expansion?
  4. What is a term bond?
  5. What is a serial bond?
  6. What is an indenture?
  7. A company is forced into bankruptcy. Assuming that the bankruptcy petition is not dismissed by the court, what are the two possible outcomes of a bankruptcy?
  8. The Arapo Corporation issued $10 million in term bonds that are callable. What information does the term “callable” indicate to decision makers?
  9. On January 1, Year One, the Rexal Company issues term bonds with a face value of $30 million that pay a stated cash interest rate of 6 percent. The bonds are actually issued for $27 million to yield an effective interest rate of 8 percent. If the first payment is made on December 31, Year One, how much cash is paid?
  10. What is a mortgage agreement?
  11. The Philadelphia Corporation issues $17 million in debentures. What is a debenture?
  12. A company issues $12 million in term bonds on March 1, Year One, for face value. The bonds pay a stated cash interest rate of 10 percent per year. Interest payments are made every February 28 and August 31. On financial statements for Year One, what is recognized as interest expense on the income statements? What interest payable is reported on the December 31, Year One, balance sheet?
  13. A company issues $18 million in term bonds on March 1, Year One, for face value plus accrued interest. The bonds pay a stated cash interest rate of 10 percent per year. Interest payments are made every January 31 and July 31. Prepare journal entries on March 1, Year One, July 31, Year One, and December 31, Year One?
  14. The Shelby Corporation issues $10 million in zero-coupon bonds. What is a zero-coupon bond? Why would an investor be willing to acquire a zero-coupon bond? How is the price of a zero-coupon bond determined?
  15. What is meant by the term “compounding”?
  16. On January 1, Year One, a zero-coupon bond with a face value of $12 million is issued for $7.8 million to create an effective annual interest rate of 9 percent. The bond will be paid in exactly five years. If the effective rate method is applied, what liability balance is reported on December 31, Year One, and also on December 31, Year Two?
  17. Do Problem 16 again but assume that the straight-line method is used rather than the effective rate method.
  18. Why is the straight-line method of recognizing interest on a bond that is issued at a discount not viewed as theoretically appropriate? When can the straight-line method be used in connection with the reporting of bond interest?
  19. On January 1, Year One, a company issues term bonds with a face value of $20 million and an annual stated cash interest rate of 6 percent. Assume the bonds are issued for $18 million to earn an effective yield rate of 8 percent per year. If the first interest payment is made on December 31, Year One, what is the liability balance reported on the balance sheet at the end of that day?
  20. On January 1, Year One, the Vallee Corporation issues a five-year $10 million serial bond paying a stated annual cash interest rate each December 31 of 5 percent. What are the cash payments specified by this bond contract?

True or False

  1. ____ A company borrows $1 million on a term bond that pays 8 percent cash interest each year. The money is used by the company to create additional profits of $93,000 per year. This company is using financial leverage.
  2. ____ One advantage of debt financing is that the payments made on the liability are tax deductible.
  3. ____ Companies that are forced into bankruptcy will have their assets liquidated with the resulting money going to pay the creditors.
  4. ____ Banks typically charge stronger companies higher interest rates than weaker ones because a financially healthy company can better afford to pay the extra amounts each period.
  5. ____ All bonds are issued for cash amounts equal to their face value.
  6. ____ A callable bond can be exchanged by the creditor for the capital stock of the debtor company.
  7. ____ A serial bond is a debt that pays interest more frequently than just once each year.
  8. ____ A debenture is a debt that is not secured.
  9. ____ The term “indenture” refers to a bond contract.
  10. ____ A term bond pays interest each February 1 and August 1. It is issued on February 1, Year One. The company will report interest expense on its Year One income statement for 11 months.
  11. ____ When a company issues a bond between interest dates, the first interest payment will be reduced.
  12. ____ A zero-coupon bond is issued for a price determined by computing the present value of the stated cash interest payments.
  13. ____ A company recognizes interest expense for the current year of $23,000 but pays cash interest of only $18,000. The $5,000 difference is compounded.
  14. ____ On January 1, Year One, a company issues a $1 million term bond that pays a stated cash interest rate of 8 percent per year at the end of each year. To determine the price of this bond, the present value of a single amount of $1 million must be determined along with the present value of an annuity due of $80,000.
  15. ____ A company issues a $1 million term bond for $700,000. The $300,000 discount can never be recognized as interest expense through the use of the straight-line method.
  16. ____ A serial bond is issued on December 31, Year One, for $885,000. Interest of $17,000 is compounded at the end of Year Two, and the first principal payment of $50,000 is made on that date. The liability balance to be reported on the December 31, Year Two, balance sheet is $818,000.

Multiple Choice

  1. A company needs to raise $9 million and issues bonds for that amount rather than additional capital stock. Which of the following is not a likely reason the company chose debt financing?

    1. Management hopes to increase profits by using financial leveraging.
    2. The cost of borrowing is reduced because interest expense is tax deductible.
    3. Adding new owners increases the possibility of bankruptcy if economic conditions get worse.
    4. If money becomes available, the company can rid itself of debts.
  2. A company issues bonds with a face value of $12 million on June 1, Year One, for the face value plus accrued interest. The bonds pay an annual cash interest rate of 10 percent with payments made on April 1 and October 1 of each year. On financial statements as of December 31, Year One, and the year then ended, which of the following balances will appear?

    1. Interest expense: $400,000; interest payable: -0-
    2. Interest expense: $600,000; interest payable: -0-
    3. Interest expense: $700,000; interest payable: $300,000
    4. Interest expense: $900,000; interest payable: $300,000
  3. The Akimbo Company issues bonds with a face value of $12 million on June 1, Year One, for 93 percent of face value plus accrued interest. The bonds pay an annual cash interest rate of 10 percent with payments made on April 1 and October 1 of each year. The bonds were sold at a discount to create an effective interest rate of 12 percent per year. What amount of cash interest will Akimbo actually pay during Year One?

    1. $400,000
    2. $600,000
    3. $700,000
    4. $900,000
  4. Kitten Inc. issued $105,000 in bonds on September 1 for face value plus any accrued interest. The annual interest rate is 6 percent, and interest is paid on the bonds every June 30 and December 31. When the bonds are issued on September 1, how much cash will the company collect?

    1. $105,000
    2. $106,050
    3. $106,575
    4. $108,150
  5. The Alexander Company issues a fifteen-year, zero-coupon bond with a face value of $500,000. The effective interest negotiated by the parties to the exchange was an annual rate of 7 percent. The present value of $1 in 15 periods at an annual interest rate of 7 percent is $0.36245. The present value of an ordinary annuity of $1 for 15 periods at an annual interest rate of 7 percent is $9.10791. The present value of an annuity due of $1 for 15 periods at an annual interest rate of 7 percent is $9.74547. What was the exchange price for the bond (rounded)?

    1. $181,225
    2. $192,687
    3. $318,777
    4. $341,091
  6. A zero coupon bond with a face value of $900,000 is issued on January 1, Year One. It will mature in ten years and was issued for $502,550 to earn an annual effective rate of 6 percent. If the effective rate method is used, what interest expense does the company recognize for Year Two (rounded)?

    1. $30,153
    2. $31,962
    3. $38,128
    4. $39,745
  7. A zero coupon bond with a face value of $600,000 is issued on January 1, Year One. It will mature in five years and was issued for $408,350 to earn an annual effective rate of 8 percent. If the effective rate method is used, what liability balance does the company report at the end of Year Two (rounded)?

    1. $476,299
    2. $478,821
    3. $482,678
    4. $485,010
  8. A zero coupon bond with a face value of $800,000 is issued on January 1, Year One. It will mature in eight years and was issued for $541,470 to earn an annual effective rate of 5 percent. If the straight-line method is used, what liability balance does the company report at the end of Year Two (rounded)?

    1. $601,350
    2. $602,974
    3. $604,755
    4. $606,102
  9. On January 1, Krystal Corporation issued bonds with a face value of $100,000 and a 4 percent annual stated interest rate. The effective annual rate of interest negotiated by the parties was 6 percent. Interest is paid semiannually on June 30 and December 31. The bonds mature in ten years. The present value of $1 in 10 periods at a 4 percent interest rate is $0.67556, in 10 periods at 6 percent interest is $0.55839, in 20 periods at a 2 percent interest rate is $0.67297, and in 20 periods at a 3 percent interest rate is $0.55368. The present value of an ordinary annuity of $1 for 10 periods at a 4 percent interest rate is $8.11090, for 10 periods at 6 percent interest is $7.36009, for 20 periods at a 2 percent interest rate is $16.35143, and in 20 periods at a 3 percent interest rate is $14.87747. What will be the price of the bonds on January 1 (rounded)?

    1. $85,123
    2. $85,279
    3. $86,054
    4. $86,311
  10. On January 1, Year One, Giant Company decides to issue term bonds with a total face value of $1 million. The bonds come due in ten years and pay cash interest of 4 percent each year on December 31. An investor is found for these bonds, but that person wants to earn an annual effective rate of 8 percent. After some serious negotiations, Giant agrees to a 7 percent annual rate, and the bonds are issued for a total of $789,292. The effective rate method is applied to recognize interest. What amount of interest expense should be recognized by Giant on its Year Two income statement (rounded)?

    1. $48,515
    2. $50,375
    3. $52,936
    4. $56,318
  11. On January 1, Year One, Super Company decides to issue term bonds with a total face value of $600,000. The bonds come due in six years and pay cash interest of 3 percent each year on December 31. An investor is found and an effective annual interest rate of 8 percent is agreed to by all parties. As a result, the bond is issued for $461,315. The effective rate method is applied. What was the reported balance of this liability at the end of Year One (rounded)?

    1. $473,018
    2. $476,550
    3. $477,105
    4. $480,220
  12. On January 1, Year One, the Elizabeth Corporation issues a $1 million serial bond. Beginning on December 31, Year One, the company will pay $100,000 per year plus interest at an 8 percent rate on the unpaid balance during that year. The bond will be issued at an effective rate of 9 percent per year. How much cash will the company pay on December 31, Year Two?

    1. $162,000
    2. $172,000
    3. $180,000
    4. $184,000
  13. On January 1, Year One, the Benson Company issues a $400,000 serial bond. Beginning on December 31, Year One, the company will pay $100,000 per year plus interest at a 4 percent rate on the unpaid balance during that year. The bond is issued for $373,740 to earn an effective annual interest rate of 7 percent. What is the liability balance reported on this company’s balance sheet as of December 31, Year One (rounded)?

    1. $278,750
    2. $281,865
    3. $283,902
    4. $285,776

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while warming up to go jogging, your roommate poses this question: “My parents plan to build four new shops in the next year or so. They will need several million dollars to construct these facilities and add the necessary equipment and furniture. I thought they were going to obtain this money by adding one or two new owners. Instead, they borrowed the money by issuing bonds to a number of investors throughout the state. I don’t like debt; it scares me. I don’t understand why they would have taken on so much debt when they could simply have gotten new ownership involved. Why would they have made this decision? How will this affect their financial statements in the future?” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has grown and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We are beginning a major expansion project that will cost us about $10 million. We plan to raise the needed money by issuing bonds. One of my partners wants to issue zero-coupon bonds. Our lawyer tells us that we really should issue serial bonds. Our financial advisor suggests term bonds. I am not even sure I know the difference. Can you explain how these three types of bonds differ? How do those differences impact the financial reporting?” How would you respond?

Problems

  1. Joni Corporation borrows $500,000 from Friendly Bank on February 1, Year One. The principal will not be repaid until the end of six years, but interest payments are due every February 1 and August 1 beginning on August 1, Year One. The interest rate is 4 percent annually. Record the journal entry or adjusting entry necessary for each of the following.

    1. The signing of the loan on February 1, Year One.
    2. The payment of interest on August 1, Year One.
    3. The recognition of accrued interest on December 31, Year One.
    4. The payment of interest on February 1, Year Two.
  2. Colson Corporation produces women’s clothing. Company officials decide to issue $50,000 in long-term bonds to finance an expansion of its swimwear line. These bonds are issued for face value on April 1, Year One and pay interest in the amount of 5 percent annually. Interest payments are made semiannually, every April 1 and October 1. Record the journal entry or the adjusting necessary for each of the following.

    1. The issuance of the bonds.
    2. The first payment of interest on October 1, Year One.
    3. The accrual of interest on December 31, Year One, so that financial statements can be prepared.
    4. The payment of interest on April 1, Year Two.
  3. Assume the same facts as in problem 2, but instead of April 1, Year One, the bonds are issued on July 1, Year One. The bonds are issued for face value plus accrued interest. Record the journal entry or adjusting entry necessary for each of the following.

    1. The issuance of the bonds on July 1, Year One.
    2. The first payment of interest on October 1, Year One.
    3. The accrual of interest on December 31, Year One, so that financial statements can be prepared.
    4. The payment of interest on April 1, Year Two.
  4. Keller Corporation offers to issue zero-coupon bonds of $80,000 on January 1, Year One. The bonds will come due on December 31, Year Three. Keller and several potential creditors negotiate an annual interest rate of 7 percent on the bonds. The present value of $1 in 3 periods at an annual interest rate of 7 percent is $0.81630. The present value of an ordinary annuity of $1 for 3 periods at an annual interest rate of 7 percent is $2.62432. The present value of an annuity due of $1 for 3 periods at an annual interest rate of 7 percent is $2.80802.

    1. Determine the amount the creditors will pay on January 1, Year One, for these bonds.
    2. Record the issuance of the bonds on January 1, Year One.
    3. Make the necessary adjusting entry at the end of Year One. What is the liability balance at the end of Year One?
    4. Make the necessary adjusting entry at the end of Year Two. What is the liability balance at the end of Year Two?
  5. The Rangaletta Company issues a five-year, zero-coupon bond on January 1, Year One. The bond has a face value of $200,000 and is issued to yield an effective interest rate of 9 percent. Rangaletta receives $129,986. On January 1, Year Three, Rangaletta pays off the bond early by making a payment of $155,000 to the bondholder. Make all journal entries from January 1, Year One, through January 1, Year Three assuming the effective rate method is applied.
  6. Do problem 5 again but assume that the straight-line method is used.
  7. A company issues $600,000 in zero-coupon bonds on January 1, Year One. They come due in exactly six years and are sold to yield an effective interest rate of 4 percent per year. They are issued for $474,186. The effective rate method is applied.

    1. What interest expense was recognized for Year One and for Year Two?
    2. How would the company’s net income have been affected in each of the first two years if the straight-line method had been used rather than the effective rate method?
  8. On January 1, Year One, Gijulka Corporation offers to issue a $100,000 bond coming due in exactly ten years. This bond pays a stated cash interest rate of 6 percent per year on December 31. A buyer is found. After some negotiations, the parties agree on an effective annual yield rate of 7 percent. Consequently, the bond is issued for $92,974. The effective rate method is applied.

    1. What figures will be reported for this bond in Gijulka’s Year One financial statements?
    2. What figures will be reported for this bond in Gijulka’s Year Two financial statements?
  9. Jaguar Corporation issues term bonds with a face value of $300,000 on January 1, Year One. The bonds have a stated rate of interest of 7 percent per year and a life of four years. They pay this interest annually on December 31. Because the market rate of interest at that time was 9 percent, the bonds were issued at a discount to create an effective annual rate of 9 percent. The present value of $1 in 4 periods at an annual interest rate of 9 percent is $0.70843. The present value of an ordinary annuity of $1 for 4 periods at an annual interest rate of 9 percent is $3.23972.

    1. What amount will Jaguar receive when the bonds are issued?
    2. What journal entry does the company make on January 1, Year One, when the bonds are issued?
    3. What journal entry or entries does the company make on December 31, Year One?
    4. What is the liability balance reported on the December 31, Year One, balance sheet?
    5. What journal entry or entries does the company make on December 31, Year Two?
    6. What is the liability balance reported on the December 31, Year Two, balance sheet?
  10. Arizona Corporation issues term bonds with a face value of $800,000 on January 1, Year One. The bonds have a stated rate of interest of 7 percent per year and a life of six years. They pay interest annually on December 31. These bonds were issued at $695,470 to create an effective annual rate of 10 percent.

    1. What journal entry does the company make on January 1, Year One, when the bonds are issued?
    2. What journal entry or entries does the company make on December 31, Year One?
    3. What is the liability balance reported on the December 31, Year One, balance sheet?
    4. What journal entry or entries does the company make on December 31, Year Two?
    5. What is the liability balance reported on the December 31, Year Two, balance sheet?
  11. Collins Company issues term bonds with a face value of $100,000 on January 1, Year One. The bonds have an annual stated rate of interest of 4 percent and a life of ten years. They pay interest semiannually on June 30 and December 31. The bonds were issued to yield an effective annual interest rate of 6 percent.

    The present value of $1 in 10 periods at a 4 percent interest rate is $0.67556, in 10 periods at 6 percent interest is $0.55839, in 20 periods at a 2 percent interest rate is $0.67297, and in 20 periods at a 3 percent interest rate is $0.55368.

    The present value of an ordinary annuity of $1 for 10 periods at a 4 percent interest rate is $8.11090, for 10 periods at 6 percent interest is $7.36009, for 20 periods at a 2 percent interest rate is $16.35143, and in 20 periods at a 3 percent interest rate is $14.87747.

    1. Prepare the journal entry to record the issuance of the bonds on January 1, Year One.
    2. Prepare the journal entry to record the first payment of interest on June 30, Year One.
    3. Prepare the journal entry to record the second payment of interest on December 31, Year One.
    4. What amount of interest expense is reported on the Year One income statement?
    5. What is the liability balance to be reported for this bond on a December 31, Year One, balance sheet?
  12. Chyrsalys Corporation issues $4,000,000 in serial bonds on January 1, Year One, with a stated cash interest rate of 4 percent. The bonds are issued at face value. The bond terms specify that interest and $2,000,000 in principal will be paid on December 31, Year One and December 31, Year Two.

    1. What journal entry, or entries, is recorded on December 31, Year One?
    2. What journal entry, or entries, is recorded on December 31, Year Two?
  13. The Empire Company issues $3 million in bonds on January 1, Year One. The bonds are for three years with $1 million paid at the end of each year plus interest of 6 percent on the unpaid balance for that period. These bonds are sold to yield an effective rate of 8 percent per year. The present value of $1 at an 8 percent interest rate in one year is $0.92593, in two years is $0.85734, and in three years is $0.79383. The present value of an ordinary annuity of $1 at an 8 percent interest rate over three years is $2.57710.

    1. What amount of cash will Empire pay on December 31 of each of these three years?
    2. What is the present value of these cash payments at an 8 percent effective annual interest rate?
    3. What journal entry or entries is recorded on December 31, Year One?
    4. What journal entry or entries is recorded on December 31, Year Two?
  14. The Althenon Corporation issues bonds with a $1 million face value on January 1, Year One. The bonds pay a stated interest rate of 5 percent each year on December 31. They come due in eight years. The Zephyr Corporation also issues bonds with a $1 million face value on January 1, Year One. These bonds pay a stated interest rate of 8 percent each year on December 31. They come due in eight years. Both companies actually issue their bonds to yield an effective annual interest rate of 10 percent. Both companies use the effective rate method. The present value of $1 at a 10 percent interest rate in eight years is $0.46651. The present value of an ordinary annuity of $1 at a 10 percent interest rate over eight years is $5.33493.

    1. What interest expense does Althenon report for Year One and also for Year Two?
    2. What interest expense does Zephyr report for Year One and also for Year Two?
  15. On January 1, Year One, the Pulaski Corporation issues bonds with a face value of $1 million. These bonds come due in twenty years and pay an annual stated interest rate (each December 31) of 5 percent. An investor offers to buy the entire group of bonds for an amount that will yield an effective interest rate of 10 percent per year. Company officials negotiate and are able to reduce the effective rate by 2 percent to 8 percent per year. The present value of $1 at a 10 percent interest rate in twenty years is $0.14864. The present value of an ordinary annuity of $1 at a 10 percent interest rate over twenty years is $8.51356. The present value of $1 at an 8 percent interest rate in twenty years is $0.21455. The present value of an ordinary annuity of $1 at an 8 percent interest rate over twenty years is $9.81815.

    1. As a result of the 2 percent reduction in the annual effective interest for this bond, what is the decrease in the amount of interest expense that Pulaski recognizes in Year One?
    2. As a result of the 2 percent reduction in the annual effective interest for this bond, what is the decrease in the amount of interest expense that Pulaski recognizes in Year Two?

Comprehensive Problem

This problem will carry through several chapters, building in difficulty. It allows students to continually practice skills and knowledge learned in previous chapters.

In Chapter 13 “In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities?”, financial statements for January were prepared for Webworks. They are included here as a starting point for the required recording for February.

Figure 14.29 Webworks Financial Statements

Figure 14.30

Figure 14.31

The following events occur during February:

  1. Webworks starts and completes nine more sites and bills clients for $5,400.
  2. Webworks purchases supplies worth $150 on account.
  3. At the beginning of February, Webworks had nineteen keyboards costing $117 each and ten flash drives costing $20 each. Webworks uses periodic FIFO to cost its inventory.
  4. On account, Webworks purchases seventy keyboards for $118 each and one hundred of the new flash drives for $22 each.
  5. On February 1, Webworks borrows $3,000 from Local Area Bank. The loan plus accrued interest will be repaid at the end of two years. The interest rate is 6 percent.
  6. Webworks purchases new computer equipment for use in designing Web sites. The equipment costs $5,500 and was paid for in cash.
  7. Webworks pays Nancy Po (company employee) $800 for her work during the first three weeks of February.
  8. Webworks sells seventy keyboards for $11,250 and ninety of the new flash drives for $2,700 cash.
  9. Webworks collects $5,200 in accounts receivable.
  10. Webworks purchases one hundred shares of RST Company for $18 per share in cash. This is considered a trading security.
  11. Webworks pays off its salaries payable from January.
  12. Webworks is hired to design Web sites for a local photographer and bakery. It is paid $600 in advance.
  13. Webworks pays off $11,300 of its accounts payable.
  14. Webworks pays Leon Jackson (company owner) a salary of $2,000.
  15. Webworks completes the salon Web site and earns the $450 paid in January.
  16. RST Company pays Webworks a dividend of $25.
  17. Webworks pays taxes of $1,558 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for February.
    4. Prepare adjusting entries for the following and post them to your T-accounts.
  18. Webworks owes Nancy Po $220 for her work during the last week of February.
  19. Leon’s parents let him know that Webworks owes $300 toward the electricity bill. Webworks will pay them in March.
  20. Webworks determines that it has $70 worth of supplies remaining at the end of January.
  21. Prepaid rent should be adjusted for February’s portion.
  22. Prepaid advertising should be adjusted for February’s portion.
  23. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  24. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method. The new equipment will also be depreciated over five years using the straight-line method.
  25. The license agreement should be amortized over its one-year life.
  26. QRS Company is selling for $12 per share and RST is selling for $16 per share on February 28.
  27. Interest should be accrued for February.
  28. Record cost of goods sold.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements for February.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in Marriott International. The partner is aware that Marriott builds a lot of hotels and, therefore, probably has to borrow a significant amount of money. The partner is curious as to the cost of the interest on the money that Marriott borrows. The partner asks you to look at the 2010 financial statements for Marriott by following this path:

  • Go to http://www.marriott.com.
  • At the bottom of this screen, click on “About Marriott.”
  • At the top of the next screen, on the right, click on “Investors.”
  • On the next screen, on the right side, click on “2010 Annual Report” to download.
  • On the next screen, click on “Financials” at the top right side.
  • On the next screen, click on “Financial Statements” on the left side.
  • The company’s income statement should appear. Review the contents of that statement.
  • Click the number 2 at the top of the screen to see the balance sheet. Review the contents of that statement.
  • On the left side of the screen, click on “Notes to Financial Statements.”
  • Go to note 13 “Long-term debt.” A schedule of the company’s senior notes can be found in that note.
  1. What was the amount of interest expense the company recognized on its 2010 income statement? How did that number compare with the interest expense recognized in 2009?
  2. What was the amount of long-term debt reported by the company on its balance sheet at the end of 2010? How did that number compare with the long-term debt at the end of 2009?
  3. According to the information in note 13, what was the stated cash interest rate for the various senior notes that the company has outstanding? What was the effective interest rate on each of these senior notes?

Chapter 13: In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 13 “In a Set of Financial Statements, What Information Is Conveyed about Current and Contingent Liabilities?”.

13.1 The Basic Reporting of Liabilities

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Define a liability by listing its essential characteristics.
  2. Differentiate a current liability from a noncurrent liability.
  3. Explain the significance that current liabilities have for investors and creditors who are studying the financial health and future prospects of an organization.
  4. Compute the current ratio.
  5. Identify the appropriate timing for the recognition of a liability.

Current and Noncurrent Liabilities

Question: The June 30, 2011, consolidated balance sheet for The Procter & Gamble Company reports total liabilitiesProbable future sacrifices of economic benefits arising from present obligations; the debts of an organization. of over $70 billion, including current liabilities of approximately $27 billion. In contrast, the business held only $2.8 billion in cash and cash equivalents.

For reporting purposes, Procter & Gamble divided its current liabilitiesDebts that will be satisfied within one year from the date of a balance sheet. into several specific categories:

  • Accounts payable ($8.0 billion)
  • Accrued and other liabilities ($9.3 billion)
  • Debt due within one year ($10.0 billion)

When creating a balance sheet, what is reported as a liability? Why are some of these liabilities shown as current whereas others are not? How does an accountant draw a distinction between liabilities that are labeled as current and those that are reported as noncurrent?

 

Answer: A liability is an obligation owed to a party outside the reporting organization—a debt that can be stated in monetary terms. Liabilities normally require the payment of cash but might at times be settled by the conveyance of other assets or the delivery of services. Some reported liabilities are for definite amounts, although a significant number are no more than estimations.

The distinction between current and noncurrent liabilitiesDebts that will not be satisfied within one year from the date of a balance sheet. is a function of time. A debt that is expected to be satisfied within one year from the balance sheet date is normally classified as a current liability.In upper-level accounting courses, the definition of a current liability is refined a bit. It refers to any liability that will require the use of a current asset or the creation of another current liability. However, the one-year standard presented in this textbook is sufficient in a vast majority of cases. Amounts owed for rent, insurance, utilities, inventory purchases, and the like usually fall into this category. If payment will not be made until after that one-year interval, the liability is reported as noncurrent. Bonds and notes payable are common examples of noncurrent debts as are liabilities for employee pensions, long-term leases, and deferred income taxes. Current liabilities are listed before noncurrent liabilities on a balance sheet.

The Importance of Information about Liabilities

Question: Figure 13.1 “Liability Section of Balance Sheet, Johnson & Johnson as of January 2, 2011” is the liability section of the balance sheet reported by Johnson & Johnson as of January 2, 2011. Note that additional information about many of these liabilities is available in the notes to the company’s financial statements.

Figure 13.1 Liability Section of Balance Sheet, Johnson & Johnson as of January 2, 2011

Investors and creditors (and other interested parties) who analyze an organization such as Johnson & Johnson usually spend considerable time studying the data that is provided about liabilities, often focusing on current liabilities. Why is information about liabilities, especially the size and composition of current liabilities, considered so important when assessing the financial position and economic health of a business?

 

Answer: Liabilities represent claims to a company’s assets. Debts must be paid as they come due or the entity risks serious consequences. Missed payments might damage a company’s ability to obtain additional credit in the future. Unfortunately, even bankruptcy can quickly become a possibility if obligations are not met.

To stay viable, organizations have to manage their liabilities carefully. They must be able to generate sufficient cash on an ongoing basis to meet all required payments. Virtually no other goal can be more important, both to company officials and external decision makers.

In general, the larger a liability total is in comparison to the reported amount of assets, the riskier the financial position. The future is always cloudy for a business when the size of its debts begins to approach the total of its assets. The amount reported as current liabilities is especially significant because those debts must be satisfied in the near future. Cash has to be available quickly, often within weeks or months.

Not surprisingly, decision makers become concerned when the reported total for current liabilities is high in comparison with current assets. The essential question is obvious: will the organization be able to meet those obligations as they come due? In a newspaper account about the financial difficulties of Advanced Cell Technology, the following warning was issued: “It reported $17 million in current liabilities, but only $1 million in cash and other current assets, an indication it could be forced to file for bankruptcy protection.”Todd Wallack, “Fame-courting biotech running short of cash,” The Boston Globe, July 17, 2008, A-1.

As mentioned in an earlier chapter, one vital sign monitored by decision makers in judging the present level of risk posed by a company’s liability requirements is the current ratioFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities.: current assets divided by current liabilities. The current ratio is a simple benchmark that can be easily computed using available balance sheet information. Although many theories exist as to an appropriate standard, any current ratio below 1.00 to 1.00 signals that the company’s current liabilities exceed its current assets. Figure 13.2 “Sample of Recent Current Ratios as of January 29, 2011” presents recent current ratios for three well-known companies: TargetDillard’s, and Aeropostale.

Figure 13.2 Sample of Recent Current Ratios as of January 29, 2011

Test Yourself

Question:

The Petersen Company currently holds $500,000 in current assets and $200,000 in current liabilities. The company borrows $60,000 cash. However, a question arises as to whether this debt is a current or noncurrent liability. Which of the following statements is true?

  1. If the liability is noncurrent, the transaction has no impact on the current ratio.
  2. If the liability is noncurrent, the transaction causes the current ratio to increase.
  3. If the liability is current, the transaction has no impact on the current ratio.
  4. If the liability is current, the transaction causes the current ratio to increase.

Answer:

The correct answer is choice b: If the liability is noncurrent, the transaction causes the current ratio to increase.

Explanation:

If the liability incurred here is noncurrent, the transaction causes current assets to go up by $60,000, but there is no change in current liabilities. Thus, the current ratio (current assets divided by current liabilities) will be higher. If the liability is current, the transaction causes both the current asset total and the current liability total to increase by $60,000. The current ratio is no longer 2.50 to 1.00 ($500,000/$200,000) but will fall to 2.15 to 1.00 ($560,000/$260,000).

Characteristics of a Liability

Question: In the real world of business, organizations are not inclined to report more liabilities than necessary because of potential damage to the image being portrayed. The inclusion of debts usually makes a company look riskier to creditors and investors. Thus, the danger that officials will report an excessive amount of liabilities seems slight. Balance sheets look better to decision makers if fewer obligations are present to drain off financial resources. Consequently, where possible, officials probably have a tendency to limit the debts that are reported. At what point does an entity have to recognize a liability? How does U.S. GAAP ensure that all liabilities are appropriately included on a balance sheet?

 

Answer: FASB Statement of Financial Accounting Concepts No. 6 defines many of the elements found in a set of financial statements. According to this guideline, a liability should be recognized when all of the following characteristics exist:

  1. There is a probable future sacrifice
  2. This sacrifice involves the reporting entity’s assets or services.
  3. The sacrifice arises from a present obligation that is the result of a past transaction or event.

To understand the reporting of liabilities, several aspects of these characteristics are especially important to note. First, the obligation does not have to be absolute before recognition is required. A future sacrifice only has to be “probable.” This standard leaves open a degree of uncertainty. As might be expected, determination as to whether a potential payment is probable or not can be a point of close scrutiny when independent CPAs audit a set of financial statements. The line between “probable” and “not quite probable” is hardly an easily defined benchmark.

Second, for reporting to be required, a debt must result from a past transaction or event.

  • An employee works for a company and is owed a salary. The work previously performed is the past event that creates the obligation.
  • A vendor delivers merchandise to a business. Receipt of these purchased goods is the past event that creates the obligation.

Third, the past transaction or event must create a present obligation. In other words, an actual debt must exist and not just a potential debt. Ordering a piece of equipment is a past event but, in most cases, no liability has yet been incurred. In contrast, the delivery of this equipment probably does obligate the buyer and, thus, necessitates the reporting of a debt. Often, in deciding whether a liability should be recognized, the accountant must address two key questions: what event actually obligates the company, and when did that event occur?

Determining all of the liabilities to be included on a balance sheet often takes considerable thought and analysis. Accountants for the reporting company produce a list of debts that meet the characteristics listed above. The independent auditor then spends considerable time and energy searching for any other obligations that might have been omitted, either accidentally or on purpose.

Key Takeaway

Because of the negative impact on the information being reported, companies prefer not to include liabilities. An excessive debt load, especially in regard to current liabilities, makes a company’s financial affairs appear riskier. Current liabilities typically are those debts that must be satisfied within one year from the balance sheet date. Because a company must be able to meet these debts as they come due, analysts pay close attention to this total. For the same reason, the current ratio (current assets divided by current liabilities) is also watched closely as a sign of financial strength. To prevent misleading financial statements, U.S. GAAP has established guidelines to help ensure the proper inclusion of liabilities. When specified characteristics are met, a liability must be reported. Thus, a liability must be reported to reflect a probable future sacrifice of an entity’s assets or services arising from a present obligation that is the result of a past transaction or event.

13.2 Reporting Current Liabilities Such as Gift Cards

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Define and record accrued liabilities.
  2. Report the sale and redemption of gift cards.
  3. Account for gift cards that are not expected to be redeemed.

Recognizing All of a Company’s Current Liabilities

Question: Current liabilities often include rent payable, salary payable, insurance payable, and the like. These debts are incurred in connection with day-to-day operations. The amounts are known and payment will be made within a relatively short period of time.

Liabilities that result from physical events such as the purchase of inventory or supplies are often reported under the generic title “accounts payable.” Other current debts (interest payable or rent payable, for example) are sometimes grouped together as accrued liabilitiesLiabilities that grow gradually because of the passage of time; common examples include salaries, rent, and interest. because they grow gradually in size over time rather than through a specific transaction. How does an organization determine the amount of current liabilities to be reported on its balance sheet?

 

Answer: As discussed in a previous chapter, the timing for the recognition of a purchase is guided by the FOB point specified by the seller or negotiated by the parties. If marked “FOB shipping point,” the liability is reported by the buyer when the goods leave the seller’s place of business. “FOB destination” delays recording until the merchandise is received by the buyer. Unless goods are damaged during transit or a dispute arises over payment for transportation charges, the FOB point is only relevant near the end of the fiscal year as the accountant attempts to separate transactions between one period and the next.

Many other liabilities are not created by a specific event but rather grow gradually day by day. Interest and rent are common examples but salaries, payroll taxes, and utilities also accrue in the same manner. They increase based on the passage of time. Interest on a loan or the amount due to an employee gets larger on a continual basis until paid. Adjusting entries are required at the end of a period to recognize any accrued liabilities that have been omitted from the general ledger.

To illustrate, assume a large group of employees earns total wages of $10,000 per day. They work Monday through Friday with payment made on the final day of each week. If the company’s fiscal year ends on a Wednesday, an adjustment is necessary so that both the expense on the income statement and the liability on the balance sheet are presented fairly for the three days that passed without payment. The adjustment shown in Figure 13.3 “Year-End Adjusting Entry to Recognize Debt to Employees for Three Days’ Work” is made for $30,000 ($10,000 per day for three days) so that the debt incurred for salaries prior to the end of the year is reported. The expense is recognized in this period to match the cost with the revenues that were earned during these three days by the employees.

Figure 13.3 Year-End Adjusting Entry to Recognize Debt to Employees for Three Days’ Work

As a second example, assume a company borrows $100,000 from a bank on December 1 with payment to be made in six months. The bank has to earn a profit and charges a 6 percent annual interest rate. By the end of that year, the company owes interest but only for the one month that has passed. As of December 31, interest expense has grown to $500 ($100,000 principal × 6 percent × 1/12 year). This accrued liability is recognized through the adjusting entry shown in Figure 13.4 “Year-End Adjusting Entry to Recognize Interest for One Month”.

Figure 13.4 Year-End Adjusting Entry to Recognize Interest for One Month

Test Yourself

Question:

An organization rents a warehouse for $8,000 per week. Cash payments are made to the owner of the building at the end of every six weeks. No payments were made for the last four weeks of Year One but the company accountant forgot to accrue this liability. Which of the following statements is not true concerning the Year One financial statements?

  1. The current ratio is overstated.
  2. Total liabilities are understated.
  3. Net income is understated.
  4. Rent expense is understated.

Answer:

The correct answer is choice c: Net income is understated.

Explanation:

Rent expense and rent payable for these four weeks ($32,000) have been omitted. Current liabilities (and, hence, total liabilities) are understated because of the debt was never recorded. If current liabilities are too low, the current ratio (current assets/current liabilities) is too high. Rent for this period has not been recorded so the expense on the income statement is understated, which makes the reported net income too high.

Reporting the Sale of Gift Cards as a Liability

Question: The February 26, 2011, balance sheet for Best Buy Co. Inc. shows several typical current liability accounts such as accounts payable and accrued liabilities. However, a $474 million figure also appears titled “Unredeemed Gift Card LiabilitiesAn obligation arising when a business accepts cash and issues a card that can be redeemed in the future for a specified amount of assets or services..”

Over the last decade or so, the importance of gift cards has escalated dramatically as a source of revenue for many businesses. By purchasing such cards, customers obtain the right to a specified amount of goods or services. From Starbucks to McDonald’s to Amazon.com, these cards are sold to serve as gifts or merely as a convenient method for handling future payments. How does a company such as Best Buy account for the thousands of gift cards that it sells each year?

 

Answer: As stated previously, a liability represents a probable future sacrifice of an asset or service. By selling a gift card, a company has created an obligation to the customer that must be reported. Businesses such as Best Buy or Barnes & Noble accept cash but then have to be willing to hand over inventory items such as cameras or books whenever the gift card is presented. Or, perhaps, some service is due to the cardholder such as the repair of a computer or a massage. To the seller, a gift card reflects a liability but one that is not normally settled with cash. Undoubtedly, the most common type of gift card in the world is a postal stamp. When bought, the stamp provides a person with the right to receive a particular service, the mailing of a letter or package.

To illustrate, assume that a company sells ten thousand gift cards with a redemption value of $50 each. Revenue cannot be reported at the time of sale; the earning process is not yet substantially complete. No asset or service has been conveyed to the customer. Rather, as shown in Figure 13.5 “Sale of Ten Thousand $50 Gift Cards for Cash”, a liability (labeled as “unearned revenue” or “gift card liability”) is recognized to indicate that the company has an obligation to the holder of the card.

Figure 13.5 Sale of Ten Thousand $50 Gift Cards for Cash

Over time, customers will present their gift cards for selected merchandise. To complete this illustration, assume that a person uses one of the $50 cards to acquire goods that had originally cost the company $32. Upon redemption, the liability is satisfied and the revenue is recognized. This exchange is reported in Figure 13.6 “Redemption of Gift Card”. A perpetual inventory system is used in this example to demonstrate the impact on inventory and cost of goods sold.

Figure 13.6 Redemption of Gift Card

Accounting for Gift Cards That Are Never Redeemed

Question: Some gift cards are never redeemed. They might be lost or just forgotten by their owners. Does the liability for a gift card remain on a company’s balance sheet indefinitely if it is unlikely that redemption will ever occur?

 

Answer: One reason that gift cards have become so popular with businesses is that some percentage will never be redeemed. They will be misplaced, stolen, or the holder will move away or die. Perhaps the person simply does not want the merchandise that is available. In such cases, the seller received money but has never had to fulfill the obligation. The entire amount of cash from the sale of the gift card is profit.

For the accountant, a question arises as to the appropriate timing of revenue recognition from such anticipated defaults. The earning process is never substantially completed by a redemption. In theory, a company recognizes this revenue when reasonable evidence exists that the card will never be used by the customer. Practically, though, determining this precise point is a matter of speculation.

Companies typically report the revenue from unused gift cards at one of three possible times:

  1. When the cards expire if a time limit is imposed.
  2. After the passage of a specified period of time such as eighteen months or two years.
  3. In proportion to the cards that are actually redeemed. To illustrate this final option, assume that a company sells thousands of cards. Based on historical trends, company officials believe that $8,000 of these gift cards will never be turned in by their owners. If 10 percent of the expected gift cards are redeemed this month, the company can also reclassify $800 (10 percent of $8,000) from unearned revenue to revenue to reflect the estimated portion of those cards that will never be presented.

Because of this accounting issue, a note to the financial statements produced by Best Buy explains, “We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer, or (ii) the likelihood of the gift card being redeemed by the customer is remote (‘gift card breakage’), and we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. We determine our gift card breakage rate based upon historical redemption patterns.”

Test Yourself

Question:

The Boston Book Company (BBC) sells $700,000 of gift cards during Year One. Of this amount, 60 percent are redeemed before the end of the year and properly recorded. Another 4 percent expired because of time limitations. The others remain outstanding at the end of the year. The accountant for BBC did not realize that the time limitations had been reached so made no entry for the 4 percent. What is the result of the accountant’s failure to make an entry?

  1. Revenues are overstated.
  2. Net income is overstated.
  3. Liabilities are overstated.
  4. There is an impact on liabilities but not on net income.

Answer:

The correct answer is choice c: Liabilities are overstated.

Explanation:

When the gift cards were sold, the total amount was recorded as a liability to indicate that the company owed a service or an asset to the customer. At the time of redemption or expiration, this liability should have been reclassified as revenue. That adjustment was not made for the cards that had expired. The liability was not properly reduced. It remains too high while revenue (and, hence, net income) is understated because of the failure to recognize this amount.

Key Takeaway

Companies report a wide variety of current liabilities. Accounts payable are normally created by the purchase of inventory or supplies. Accrued liabilities such as rent and interest are those debts that grow gradually over time. All such liabilities must be found and recorded prior to the preparation of financial statements. One common liability is created by the sale of gift cards. In today’s retail world, many companies offer these cards in hopes of increasing profits. Because a product or service must be provided when the card is presented, the company has an obligation so that a liability is reported. This liability is later reclassified as revenue when the card is redeemed because the earning process is substantially complete at that point. Revenue should also be recorded for a gift card when it becomes likely that redemption will never occur. Cards can be lost, stolen, or the customer might die or leave the area. The revenue associated with unredeemed gift cards must be reported at an appropriate point in time such as on the date of expiration or in proportion to the redemption of other cards.

13.3 Accounting for Contingencies

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Define a commitment and explain the method by which it is reported.
  2. Define a contingency and explain the method by which it is reported.
  3. Explain the criteria that guide the reporting of a contingent loss.
  4. Describe the appropriate accounting for contingent losses that do not qualify for recognition at the present time.
  5. Describe the handling of a contingent loss that ultimately proves to be different from the originally estimated and recorded balance.
  6. Compare the reporting of contingent losses and contingent gains.

Commitments and Contingencies

Question: The December 31, 2010, balance sheet for E. I. du Pont de Nemours and Company (better known as DuPont) shows total liabilities of approximately $30.7 billion. Immediately following the liability section, a separate category titled “Commitments and Contingent Liabilities” is included but no monetary figure is presented. Note 19 to the company’s financial statements provides further details. In several pages of explanatory material, a number of future matters facing the company are described such as product warranties, environmental actions, litigation, and operating leases. In financial reporting, what is meant by the terms “commitments” and “contingencies?”

 

Answer:

Commitments. Commitments represent unexecuted contracts. A contract has been created (either orally or in writing) and all parties have agreed to the terms. However, the listed actions have not yet been performed.

For example, assume that a business places an order with a truck company for the purchase of a large truck. The business has made a commitmentAn unexecuted contract such as for the future purchase of inventory at a set price; amounts are not reported on the balance sheet or income statement because no transaction has yet occurred; disclosure of information within the financial statement notes is necessary. to pay for this new vehicle but only after delivery has been received. Although a cash payment will be required in the future, the specified event (conveyance of the truck) has not occurred. No transaction has taken place, so no journal entry is needed. The liability does not yet exist.

Information about such commitments is still of importance to decision makers because future cash payments will be required of the reporting company. However, events have not reached the point where all the characteristics of a liability are present. Thus, an extensive explanation about such commitments (as found in the notes for DuPont) is included in the notes to financial statements but no amounts are reported on either the income statement or the balance sheet. When a commitment is described, investors and creditors know that a step has been taken that will likely lead to a liability.

Contingencies. A contingencyA potential gain or loss that might eventually arise as a result of a past event; uncertainty exists as to the likelihood that a gain or loss will occur and the actual amount, if any, that will result. poses a different reporting quandary for the accountant. A past event has already occurred but the amount of the present obligation (if any) cannot yet be determined.

With a contingency, the uncertainty is about the ultimate outcome of an action that took place in the past. The accountant is not a fortune teller who can predict the future. To illustrate, assume Wysocki Corporation commits an act that is detrimental to the environment so that the federal government files a lawsuit for damages. The original action against the environment is the past event that creates the contingency. However, both the chance of losing the lawsuit and the possible amount of any penalties might not be known for several years. What, if anything, should be recognized in the interim?

Because companies prefer to avoid (or at least minimize) the recognition of losses and liabilities, authoritative guidelines are necessary to guide the appropriate reporting of contingencies. Otherwise, few if any contingencies would ever be reported.

According to U.S. GAAP, the recognition of a loss contingencyA potential loss resulting from a past event that must be recognized on an entity’s financial statements if it is deemed probable and the amount can be reasonably estimated. is required if the following are true:

  1. The loss is deemed to be probable.
  2. The amount of that loss can be reasonably estimated.

As soon as both of these criteria are met, the expected impact of the loss contingency must be recorded.

To illustrate, assume that the previous lawsuit for environmental damages was filed in Year One. Wysocki officials assess the situation. They believe that a loss is probable and that $800,000 is a reasonable estimation of the amount that will eventually have to be paid as a result of this litigation. Although this balance is only an estimate and the case may not be finalized for some time, the contingent loss is recognized, as can be seen in Figure 13.7 “Year One—Expected Loss from Lawsuit (Contingency)”.

Figure 13.7 Year One—Expected Loss from Lawsuit (Contingency)

FASB has identified a number of examples of loss contingencies that are evaluated and reported in this same manner including:

  • Collectability of receivables
  • Obligations related to product warranties and product defects
  • Risk of loss or damage of enterprise property by fire, explosion, or other hazards
  • Threat of expropriation of assets
  • Pending or threatened litigation
  • Actual or possible claims and assessments
  • Guarantees of indebtedness of others

Accounting Rules Used to Record Contingent Losses

Question: The likelihood of loss in connection with contingencies is not always going to be probable or subject to a reasonable estimation. These two criteria will be met in some but certainly not in all cases. What reporting is appropriate for a loss contingency that does not qualify for recording at the present time?

 

Answer: If a contingent loss is only reasonably possible (rather than probable) or if the amount of a probable loss does not lend itself to a reasonable estimation, only disclosure in the notes to the financial statements is necessary rather than actual recognition. Furthermore, a contingency where the chance of loss is viewed as merely remote can be omitted entirely from the financial statements.

Unfortunately, as discussed previously, official guidance provides little specific detail about what constitutes a probable, reasonably possible, or remote loss. At best, each of those terms seems vague. For example, within U.S. GAAP, “probable” is described as “likely to occur.” Thus, the professional judgment of the accountants and auditors must be relied on to determine the exact point in time when a contingent loss moves from reasonably possible to probable.

Not surprisingly, many companies contend that any future adverse effects from loss contingencies are only reasonably possible so that no actual amounts are reported on the balance sheet. Practical application of official accounting standards is not always theoretically pure, especially when the guidelines are nebulous.

Fixing an Incorrect Estimate

Question: Assume that a company recognizes a contingent loss because it is judged as probable and subject to a reasonable estimation. Eventually, most such guesses are likely to prove to be wrong, at least in some small amount. What happens when an estimate is reported in a set of financial statements and the actual total is later found to be different?

For example, as shown in Figure 13.7 “Year One—Expected Loss from Lawsuit (Contingency)”, Wysocki Corporation recognized a loss of $800,000 in Year One because of a lawsuit involving environmental damage. Assume the case is eventually settled in Year Two for $900,000. How is the additional loss of $100,000 reported? It relates to an action taken in Year One but the actual amount is not finalized until Year Two. The difference is not apparent until the later date.

 

Answer: In Year One, because both criteria for reporting were met, an $800,000 loss was recognized on the income statement along with a corresponding liability. In addition, notes to the company’s financial statement will explain the nature of this lawsuit as well as the range of any reasonably possible losses. Decision makers analyzing the Wysocki Corporation should realize that the amount reported is not meant as a precise measure of the eventual loss. The same is true of all contingencies and other estimations. By the time that the exact amount of loss is determined, investors and creditors have already incorporated the original information into their decisions, including the uncertainty of the outcome. Restating the Year One loss to $900,000 does not allow them to undo and change decisions that were made in the past.

Consequently, no alteration is made in the $800,000 figure reported for Year One. The additional $100,000 loss is recorded in Year Two. The adjustment is recognized as soon as a better estimation (or final figure) is available. This approach is required to correct any reasonable estimate. Wysocki recognizes the updated balances through the journal entry shown in Figure 13.8 “Year Two—Settlement of Lawsuit at an Amount $100,000 More than Originally Reported” that removes the liability and records the remainder of the loss that has now been incurred.

Figure 13.8 Year Two—Settlement of Lawsuit at an Amount $100,000 More than Originally Reported

One important exception to this handling does exist. If the initial estimate is viewed as fraudulent—an attempt to deceive decision makers—the $800,000 figure reported in Year One is physically restated. It simply cannot continue to appear. All amounts in a set of financial statements have to be presented in good faith. Any reported balance that fails this essential test cannot be allowed to remain. Furthermore, even if company officials made no overt attempt to deceive, restatement is still required if they should have known that a reported figure was materially wrong. Such amounts were not reported in good faith; officials have been grossly negligent in reporting the financial information.

From a journal entry perspective, restatement of a previously reported income statement balance is accomplished by adjusting retained earnings. Revenues and expenses (as well as gains, losses, and any dividends paid figures) are closed into retained earnings at the end of each year. Thus, this account is where the previous year error now resides.

Upon discovery that the actual loss from the lawsuit is $900,000, this amount is reported by one of the two approaches presented in Figure 13.9 “Two Ways to Correct an Estimate”. However, use of the second method is rare because accounting mistakes do not often reach this level of deceit or incompetence. An announcement that a company has had to “restate its earnings” is never a good sign.

Figure 13.9 Two Ways to Correct an Estimate

Test Yourself

Question:

The Red Company incurs a contingency in Year One. At that time, the company’s accountants believe that a loss of $200,000 is probable but a loss of $290,000 is reasonably possible. Nothing is settled by the end of Year Two. On that date, the accountants believe that a loss of $240,000 is probable but a loss of $330,000 is reasonably possible. All these estimations are viewed as reasonable. The contingency ends in Year Three when Red Company pays the other party $170,000 to settle the problem. What does Red Company recognize on its Year Three income statement?

  1. Gain (or Loss Recovery) of $30,000
  2. Gain (or Loss Recovery) of $70,000
  3. Gain (or Loss Recovery) of $120,000
  4. Gain (or Loss Recovery) of $160,000

Answer:

The correct answer is choice b: Gain (or Loss Recovery) of $70,000.

Explanation:

A loss of $200,000 is recognized in Year One because that amount is viewed as probable. An additional $40,000 loss is recognized in Year Two so that the total loss reported to date corresponds to the estimated $240,000 probable amount. However, the company does not lose all $240,000 that has now been recognized but only $170,000. The reduction in the reported loss increases net income by the $70,000 difference and is shown as either a gain or a loss recovery.

Gain Contingencies

Question: The previous discussion focused entirely on the accounting that is required for loss contingencies. Companies obviously can also have gain contingenciesA potential gain resulting from a past event that is not recognized in an entity’s financial statements until it actually occurs due to the conservatism inherent in financial accounting.. In a lawsuit, for example, one party might anticipate winning $800,000 but eventually collect $900,000. Are the rules for reporting gain contingencies the same as those applied to loss contingencies?

 

Answer: As a result of the conservatism inherent in financial accounting, the timing used in the recognition of gains does not follow the same rules applied to losses. Losses are anticipated when they become probable; that has long been a fundamental rule of financial reporting. The recognition of gains is delayed until they actually occur (or, at least until they reach the point of being substantially complete). Disclosure in the notes is still important but the decision as to whether the outcome is probable or reasonably possible is irrelevant in reporting a gain. As reflected in Figure 13.10 “Reporting a Gain Contingency”, gains are not anticipated for reporting purposes.

Figure 13.10 Reporting a Gain Contingency

Test Yourself

Question:

The Blue Company files a lawsuit against another company in Year One and thinks there is a good chance for a win. At that time, the company’s accountants believe that a gain of $200,000 is probable but a gain of $290,000 is reasonably possible. Nothing is settled by the end of Year Two. On that date, the accountants believe that a gain of $240,000 is probable but a gain of $330,000 is reasonably possible. The contingency is settled in Year Three when Blue Company collects $170,000. What does Blue Company recognize on its Year Three income statement?

  1. Decrease in income of $30,000
  2. Decrease in income of $70,000
  3. Decrease in income of $120,000
  4. Increase in income of $170,000

Answer:

The correct answer is choice d: Increase in income of $170,000.

Explanation:

As a gain contingency, no amount will be recognized until the point where substantial completion is reached. Consequently, no gain or loss is reported in either Year One or Year Two despite the optimism that a gain will be achieved. Thus, the entire amount of the gain is recorded when the case is settled in Year Three. That final event increases net income by $170,000.

Talking with an Independent Auditor about International Financial Reporting Standards

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: According to U.S. GAAP, a contingent loss must be recognized when it is probable and a reasonable estimation of the amount can be made. That rule has been in place now for over thirty years and is well understood in this country. Are contingent losses handled in the same way by IFRS?

Robert Vallejo: The theory is the same under IFRS but some interesting and subtle differences do exist. If there is a probable future outflow of economic benefits and the company can form a reliable estimate, then that amount must be recognized. However, the term “probable” is defined as “more likely than not” which is easier to reach than the U.S. GAAP equivalent. Thus, the reporting of more contingent losses is likely under IFRS than currently under U.S. GAAP.

IAS 37, Provisions, Contingent Liabilities and Contingent Assets, states that the amount recorded should be the best estimate of the expenditure that would be required to settle the present obligation at the balance sheet date. That is the best estimate of the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. Under U.S. GAAP, if there is a range of possible losses but no best estimate exists within that range, the entity records the low end of the range. Under IFRS, the entity records the midpoint of the range. That is a subtle difference in wording, but it is one that could have a significant impact on financial reporting for organizations where expected losses exist within a very wide range.

In July 2010, the FASB published an exposure draft, Disclosure of Certain Loss Contingencies, as investors and other users of financial reporting had expressed concerns that disclosures about loss contingencies. Many felt that existing guidance does not provide adequate and timely information to assist them in assessing the likelihood, timing, and magnitude of future cash outflows associated with loss contingencies. After receiving comments from constituents, the FASB is re-deliberating the need to update existing U.S. GAAP.

Key Takeaway

Entities often enter into contractual arrangements. Prior to performing the requirements of the contract, financial commitments frequently exist. They are future obligations that do not yet qualify as liabilities. For accounting purposes, they are only described in the notes to the financial statements. In contrast, contingencies are potential liabilities that might result because of a past event. The likelihood of loss or the actual amount of the loss both remain uncertain. Loss contingencies are recognized when their likelihood is probable and this loss is subject to a reasonable estimation. Reasonably possible contingent losses are only described in the notes whereas potential losses that are only remote can be omitted entirely from a company’s financial statements. Eventually, such estimates often prove to be incorrect and are normally fixed when first discovered. However, if fraud, either purposely or through gross negligence, has occurred, the amounts reported in prior years are restated. Contingent gains are only reported to decision makers through disclosure within the notes to the financial statements.

13.4 Accounting for Product Warranties

Learning Objectives

At the end of this section students should be able to meet the following objectives:

  1. Explain the difference between an embedded and an extended product warranty.
  2. Account for the liability and expense incurred by a company that provides customers with an embedded warranty on a purchased product.
  3. Account for the amount received on the sale of an extended warranty and any subsequent costs incurred as a result of this warranty.
  4. Compute the average age of accounts payable.

Accounting for Embedded Product Warranties

Question: U.S. GAAP includes an embedded product warrantyAn obligation established by the sale of a product where the seller promises to fix or replace the product if it proves to be defective. as one type of loss contingency. A company sells merchandise such as a car or a microwave and agrees to fix certain problems if they arise within a specified period of time. The seller might promise, for example, to replace a car’s transmission if it breaks. Making the sale with this warranty attached is the past event that creates the contingency. However, the item acquired by the customer must break before the company has an actual loss. That outcome is uncertain.

In accounting for an embedded product warranty, several estimates are required:

  • The approximate number of claims that can be expected
  • The percentage of these claims will meet the requirements of the warranty
  • The eventual cost from the average approved claim

As an example, General Electric reported on its December 31, 2010, balance sheet a liability for product warranties totaling over $1.5 billion. That is certainly not a minor obligation. In the notes to the financial statements, the company explains, “We provide for estimated product warranty expenses when we sell the related products. Because warranty estimates are forecasts that are based on the best available information—mostly historical claims experience—claims costs may differ from amounts provided.” How does a company record and report contingencies such as embedded product warranties?

 

Answer: In accounting for warranties, cash rebates, the collectability of receivables and other similar contingencies, the likelihood of loss is rarely an issue. These losses are almost always probable. For the accountant, the challenge is in arriving at a reasonable estimate of that loss. How many microwaves will break and have to be repaired? What percentage of cash rebate coupons will be presented by customers in the allotted time? How often will a car’s transmission need to be replaced?

Many companies utilize such programs on an ongoing basis so that data from previous offers will be available to help determine the amount of the expected loss. However, historical trends cannot be followed blindly. Officials still have to be alert for any changes that could impact previous patterns. For example, in bad economic periods, customers are more likely to take the time to complete the paperwork required to receive a cash rebate. Or, the terms may vary from one warranty program to the next. Even small changes in the wording of an offer can alter the expected number of claims.

To illustrate, assume that a retail store sells ten thousand compact refrigerators during Year One for $400 cash each. The product is covered by a warranty that extends until the end of Year Three. No claims are made in Year One but similar programs in the past have resulted in repairs having to be made on 3 percent of the refrigerators at an average cost of $90. Thus, the warranty on the Year One sales is expected to cost a total of $27,000 (10,000 units × 3 percent = 300 claims; 300 claims × $90 each = $27,000).

Although no repairs are made in Year One, the $27,000 liability is reported in that period. Immediate recognition is appropriate because the loss is both probable and subject to reasonable estimation. In addition, the matching principle states that expenses should be reported in the same period as the revenues they help generate. Because the revenue from the sale of the refrigerators is recognized in Year One (Figure 13.11 “Year One—Sale of Ten Thousand Compact Refrigerators for $400 Each”), the warranty expense resulting from those revenues is included at that time (Figure 13.12 “Year One—Recognize Expected Cost of Warranty Claims”).

Figure 13.11 Year One—Sale of Ten Thousand Compact Refrigerators for $400 Each

Figure 13.12 Year One—Recognize Expected Cost of Warranty Claims

This warranty is in effect until the end of Year Three. Assume that repairs made in the year following the sale (Year Two) cost the company $13,000 but are made for these customers at no charge. When a refrigerator breaks, it is fixed as promised by the warranty. Because the expense has already been recognized in the year of sale (Figure 13.12 “Year One—Recognize Expected Cost of Warranty Claims”), these payments reduce the recorded liability as is shown in Figure 13.13 “Year Two—Payment for Repair Work Covered by Embedded Warranty”. The actual costs create no additional impact on net income.

Figure 13.13 Year Two—Payment for Repair Work Covered by Embedded Warranty

At the end of Year Two, the liability balance in the general ledger holds a balance of $14,000 to reflect the expected warranty costs for Year Three ($27,000 original estimation less the $13,000 payout made for repairs to date). Because the warranty has not expired, company officials need to evaluate whether this $14,000 liability is still a reasonable estimation of the remaining costs to be incurred. If so, no further adjustment is made.

However, the original $27,000 was merely an estimate. More information is now available, some of which might suggest that $14,000 is no longer the best number to be utilized for the final year of the warranty. To illustrate, assume that a flaw has been found in the refrigerator’s design and that $20,000 (rather than $14,000) is now a better estimate of the costs to be incurred in the final year of the warranty.

The $14,000 balance is no longer appropriate. The reported figure is updated in Figure 13.14 “December 31, Year Two—Adjust Warranty Liability from $14,000 to Newly Expected $20,000” to provide a fair presentation of the data that is now available. Estimates should be changed at the point where new information provides a clearer vision of future events.

Figure 13.14 December 31, Year Two—Adjust Warranty Liability from $14,000 to Newly Expected $20,000

In this adjusting entry, the change in the expense is not recorded in the period of the sale. As discussed earlier, no retroactive restatements are made to figures previously reported unless fraud occurred or an estimate was held to be so unreasonable that it was not made in good faith.

Accounting for Extended Product Warranties

Question: Not all warranties are built into a sales transaction. Many retailers also offer extended product warrantiesAn obligation whereby the buyer of a product pays the seller for the equivalent of an insurance policy to protect against breakage or other harm to the product for a specified period of time. for an additional fee. For example, assume a business sells a high-definition television with an automatic one-year warranty. The buyer receives this warranty as part of the purchase agreement. The accounting for that first year is the same as just demonstrated; an estimated expense and liability are recognized at the time of sale.

However, an additional warranty for three more years is also offered at a price of $50. If on January 1, Year One, a customer buys a new television and also chooses to acquire this additional three-year coverage, what recording is made by the seller? Is an extended warranty purchased by a customer reported in the same manner as an automatic product warranty embedded within a sales contract?

 

Answer: Extended warranties, which are quite popular in many industries, are simply insurance policies. If the customer buys the coverage, the product is insured against breakage or other harm for the specified period of time. In most cases, the company is making the offer in an attempt to earn an extra profit. The seller hopes that the money received for the extended warranty will outweigh the eventual repair costs. Therefore, the accounting differs here from the process demonstrated previously for an embedded warranty that was provided to encourage the sale of the product. In that earlier example, all of the revenue as well as the related (but estimated) expense were recorded immediately.

By accepting money for an extended warranty, the seller agrees to provide services in the future. This contract is much like a gift card. The revenue cannot be recognized until the earning process is substantially complete. Thus, as shown in Figure 13.15 “January 1, Year One—Sale of Extended Warranty Covering Years Two through Four”, the $50 received for the extended warranty on this television is initially recorded as “unearned revenue.” This balance is a liability because the company owes a specified service to the customer. As indicated previously, liabilities do not always represent future cash payments.

Figure 13.15 January 1, Year One—Sale of Extended Warranty Covering Years Two through Four

Note in Figure 13.15 “January 1, Year One—Sale of Extended Warranty Covering Years Two through Four” that no expense was estimated and recorded in connection with this warranty. As explained by the matching principle, expenses are not recognized until the related revenue is reported.

Because of the terms specified, this extended warranty does not become active until January 1, Year Two. The television is then covered for a three-year period. The revenue is recognized, most likely on a straight-line basis, over that time. Consequently, the $50 is reported at the rate of 1/3 per year or $16.66.

Figure 13.16 December 31, Year Two (as well as Three and Four)—Recognition of Revenue from Extended Warranty

In any period in which a repair must be made, the expense is recognized as incurred because revenue from this warranty contract is also being reported. For example, assume that on August 8, Year Two, a slight adjustment must be made to the television at a cost of $9. The product is under warranty so the customer is not charged for this service. The Year Two expense shown in Figure 13.17 “August 8, Year Two—Repair of Television under Warranty Contract” is being matched with the Year Two revenue recognized in Figure 13.16 “December 31, Year Two (as well as Three and Four)—Recognition of Revenue from Extended Warranty”.

Figure 13.17 August 8, Year Two—Repair of Television under Warranty Contract

Test Yourself

Question:

A company sells a product late in Year One. The customer holds a one-year warranty on that product. The company believes the product will break in Year Two and have to be repaired at a cost of $16. Which of the following statements is true?

  1. If this is an embedded warranty that the customer received automatically when the product was acquired, the $16 expense is reported in Year One.
  2. If this is an extended warranty that the customer bought when the product was acquired, the $16 expense is reported in Year One.
  3. If this is an extended warranty that cost the customer $20, the company recognizes a $4 profit in Year One.
  4. If this is an embedded warranty that the customer received automatically when the product was acquired, revenue is recognized by the company in Year Two.

Answer:

The correct answer is choice a: If this is an embedded warranty that the customer received automatically when the product was acquired, the $16 expense is reported in Year One.

Explanation:

For an embedded warranty that comes with the purchase of a product, the expense (and related liability) is recognized immediately and no revenue is recorded for the warranty. For an extended warranty acquired by the customer, revenue is recognized over the period of coverage (like an insurance policy), and the expense is recognized as incurred. If an extended warranty was sold for $20, the expense and virtually all the revenue are reported in Year Two.

Computing the Age of Accounts Payable

Question: Previously, the current ratio (current assets divided by current liabilities) and the amount of working capitalFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. (current assets minus current liabilities) were discussed. Do investors and creditors analyze any other vital signs when analyzing the current liabilities reported by a business or other organization? Should decision makers be aware of any specific ratios or amounts in connection with current liabilities that provide especially insightful information about a company’s financial health and operations?

 

Answer: In studying current liabilities, the number of days a business takes to pay its accounts payable is usually a figure of interest. If a business begins to struggle, the time of payment tends to lengthen because of the difficulty in generating sufficient cash amounts. Therefore, an unexpected jump in this number is often one of the first signs of financial distress and warrants concern.

To determine the age of accounts payableA determination of the number of days that a company takes to pay for the inventory that it buys; computed by dividing accounts payable by the average inventory purchases made per day during the period. (or the number of days in accounts payable), the amount of inventory purchased during the year is first calculated:

cost of goods sold = beginning inventory + purchases – ending inventory.

Thus,

purchases = cost of goods sold – beginning inventory + ending inventory.

Using this computed purchases figure, the number of days that a company takes to pay its accounts payable on the average can be determined. Either the average accounts payable for the year can be used or just the ending balance.

purchases/365 = average purchases per day accounts payable/average purchases per day = average age of accounts payable

As an illustration, the information presented in Figure 13.18 “Information from 2010 Financial Statements for Safeway Inc.” comes from the 2010 financial statements for Safeway Inc.

Figure 13.18 Information from 2010 Financial Statements for Safeway Inc.

The total amount of inventory purchased by Safeway during 2010 was over $29 billion:

purchases = cost of goods sold – beginning inventory + ending inventory purchases = $29.443 billion – $2.509 billion + $2.623 billion purchases = $29.557 billion.

The average purchases amount made each day during 2010 by Safeway was nearly $81 million:

purchases/365 $29.557/365 = $80.978 million.

The average age of the reported accounts payable for Safeway at the end of 2010 was between thirty-one and thirty-two days:

accounts payable/average daily purchases $2.533 billion/$80.978 million = 31.28 days.

To evaluate that number, a decision maker needs to compare it to (a) previous time periods for that company, (b) the typical payment terms for a business in that particular industry, and (c) comparable figures from other similar corporations. Interestingly, the same computation for 2008 showed that Safeway was taking 28.48 days to pay its accounts payable during that earlier period.

Key Takeaway

Many companies incur contingent liabilities as a result of product warranties. If the warranty is given to a customer along with a purchased item, an anticipated expense should be recognized at that time along with the related liability. If the reported cost of this type of embedded warranty eventually proves to be wrong, a correction is made when discovered assuming that the original estimate was made in good faith. Companies also sell extended warranties, primarily as a means of increasing profits. These warranties are recorded initially as liabilities (unearned revenue) with that amount reclassified to revenue over the time of the obligation. Subsequent costs are expensed as incurred to be in alignment with the matching principle. Thus, for extended warranties, expenses are not estimated and recorded in advance. Analysts often calculate the average age of accounts payable to determine how quickly liabilities are being paid as a vital sign used to indicate an entity’s financial health.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: Analysts often look closely at current liabilities when evaluating the future prospects of a company. Is there anything in particular that you look for when examining a company and the reported balances for its current liabilities?

Kevin Burns: For almost any company, there are a number of things that I look at in connection with current liabilities. I always have several questions where possible answers can concern me. I am interested in the terms of the current liabilities as well as the age of those liabilities. In other words, is the company current with its payments to vendors? Does the company have a significant amount of current liabilities but only a small amount of current assets? Or, stated more directly, can these liabilities be paid on time? Have current liabilities been growing while business has remained flat or grown much more slowly? Are any of the current liabilities to organizations controlled by corporate insiders? That always makes me suspicious so that, at the very least, I want more information. In sum, I like balance sheets where there are no potential conflicts of interest and the company is a reasonably fast payer of its debts.

13.5 End-of-Chapter Exercises

Questions

  1. The Saint Louis Corporation is trying to determine whether a liability needs to be recognized in connection with an event that recently took place. What characteristics must be present before a liability has to be reported?
  2. The Topeka Company has a liability for $1.3 million. Company officials are trying to decide whether the debt should be shown as a current or noncurrent liability. How is that decision made?
  3. Why are most decision makers particularly concerned about the amount of current liabilities reported by a company?
  4. The Ames Company reports $300,000 in current assets and $100,000 in current liabilities. At the very end of the year, the company pays a $20,000 account payable. What was the current ratio before the payment? What was the current ratio after the payment?
  5. What are several examples of accrued liabilities? Why do they often require adjusting entries prior to the production of financial statements?
  6. How do companies account for gift cards that they sold?
  7. How do companies account for gift cards that are redeemed?
  8. How do companies account for gift cards that are unlikely to be redeemed?
  9. In financial reporting, what is a commitment, and how is it shown within a set of financial statements? Why is that reporting considered appropriate?
  10. The Atkinson Company has a contingent loss at December 31, Year One. It will not be completely settled for at least two years. Under what condition, should the company report a liability at the present time?
  11. Give three examples of possible contingencies that a company might have to report in its financial statements.
  12. The Salem Corporation has been sued for $2 million. Company lawyers believe that the chances of a loss are only reasonably possible. If a loss is incurred, the expected amount is $775,000. What does Salem report in connection with this contingency?
  13. The Oregon Company has been sued for $3 million. Company lawyers believe that a loss of $500,000 might result, but the chances of such a loss are really remote. How does Oregon report this contingent loss?
  14. The Randolph Corporation is being sued for $2 million. How does the reporting under U.S. GAAP differ from the reporting required under IFRS?
  15. The Remshaw Corporation has filed suit against a competitor for patent infringement. Company lawyers are confident of a positive outcome. They believe that an award of $1.2 million is probable. How does Remshaw report this contingent gain?
  16. A landscaping company sells live plants (such as azaleas) and promises to replace any plants that die within one year of purchase. At the end of the current fiscal year, how does the company determine the amount that must be reported as its liability?
  17. A company sells computers and promises to fix any problems that the customer encounters within two years of a purchase. When does the company recognize expense from this warranty program?
  18. A company sells computers and also sells an extended warranty that obligates the company to fix any problems that are encountered within two years from the purchase date. When does the company recognize expense from this warranty program?
  19. How is the age of accounts payable calculated?

True or False

  1. ____ A company has a liability, and company officials are not sure if it should be reported as a current liability or as a noncurrent liability. They are likely to prefer to report the balance as a current liability.
  2. ____ A current ratio of less than 1.0 to 1.0 means that a company has more current assets than current liabilities.
  3. ____ A company signs a contract on December 29, Year One, to buy 1,000 barrels of crude oil on January 24, Year Two, at $82 per barrel. The likelihood of this contingency is probable and, therefore, should be reported as a liability at the end of Year One.
  4. ____ Contingent liabilities should be reported on the balance sheet if they are both probable and can be reasonably estimated.
  5. ____ Because of conservatism, a contingent liability should be disclosed in a company’s financial statements even if the chance of loss is only remote.
  6. ____ Contingent gains should only be recorded if they are probable.
  7. ____ Liabilities for gift cards must remain on the balance sheet until they are redeemed, regardless of how long that takes.
  8. ____ If a gift card is redeemed, a liability is reduced for reporting purposes.
  9. ____ Restatement of previously issued financial statements will occur if a company attempts to mislead investors by understating liabilities.
  10. ____ A company has a contingent loss of $1 million. If a liability is reported using IFRS, the same monetary liability will also have to be reported according to U.S. GAAP.
  11. ____ A company has both embedded product warranties and extended product warranties. These warranties will be reported in the same way by this company.
  12. ____ A company gives customers an embedded warranty with each purchase. During the past several years, 4 percent of these products have been returned under the warranty program. Thus, the company should anticipate that 4 percent of the items sold this year will have to be fixed.
  13. ____ Company A takes twenty-two days to pay its accounts payable. Company Z takes thirty-one days to pay its accounts payable. Company A is a more financially healthy company than Company Z.

Multiple Choice

  1. Which of the following is not a criterion that must be met for an item to be classified as a liability?

    1. A certain cash payment will occur in the future.
    2. A sacrifice will require the entity’s assets or services.
    3. There is a probable future sacrifice.
    4. There is a present obligation that results from a past transaction.
  2. Watkins Inc. has the following assets at the end of Year One:

    Cash $400
    Inventory $730
    Prepaid Rent $460
    Equipment (net book value) $4,000

    Watkins also has the following liabilities at the end of Year One:

    Accounts Payable $560
    Rent Payable $200
    Note Payable, due on June 1, Year Four $3,500

    At the end of Year One, what is Watkins’s current ratio?

    1. 1.14 to 1.0
    2. 1.31 to 1.0
    3. 1.49 to 1.0
    4. 2.09 to 1.0
  3. Which of the following is the least likely to be an accrued liability?

    1. Accounts payable
    2. Interest payable
    3. Rent payable
    4. Salary payable
  4. The Taylor Company sells music systems. Each music system costs the company $100 and will be sold to the public for $250. In Year One, the company sells 100 gift cards to customers for $250 each ($25,000 in total). These cards are valid for just one year, and company officials expect them to all be redeemed. In Year Two, only 96 of the cards are returned. What amount of net income does the company report for Year Two in connection with these cards?

    1. $15,000
    2. $15,400
    3. $15,500
    4. $15,800
  5. Osgood sells music systems. Each system costs the company $100 and is sold for $250. During Year One, the company sells 1,000 of these systems ($250,000 in total). Each system comes with a free one-year warranty. The company expects 5 percent of the music systems to break and cost $40 each to fix. None break in Year One, but unfortunately, the systems were not well-manufactured, and 300 break in Year Two and cost $70 each to fix. What is the impact of this embedded warranty on Osgood’s reported net income for Year Two?

    1. Decrease of $15,000
    2. Decrease of $17,000
    3. Decrease of $19,000
    4. Decrease of $21,000
  6. The James Corporation sells music systems. Each system costs the company $100 and is sold for $250. During Year One, the company sold 1,000 music systems ($250,000 in total). Every customer also paid $10 each ($10,000 in total) for a one-year warranty. The company expects 5 percent of the music systems to break and cost $40 each to fix. None break in Year One, but unfortunately, the systems were not well-manufactured, and 300 break in Year Two and cost $70 each to fix. What is the impact of this extended warranty on James’s reported net income for Year Two?

    1. Decrease of $10,000
    2. Decrease of $11,000
    3. Decrease of $18,000
    4. Decrease of $21,000
  7. In Year One, Company A was allegedly damaged by Company Z and has filed suit for $300,000. At the end of Year One, Company A thinks it is probable that it will win $130,000 but reasonably possible that it will win $200,000. On that same day, Company Z thinks it is probable that it will lose $80,000 but reasonably possible that it will lose $180,000. On June 14, Year Two, the suit is settled when Company Z pays $97,000 in cash to Company A. Which of the following is true about the financial reporting for Year Two?

    1. Company A increases net income by $97,000; Company Z decreases net income by $17,000.
    2. Company A increases net income by $97,000; Company Z increases net income by $83,000.
    3. Company A decreases net income by $33,000; Company Z decreases net income by $17,000.
    4. Company A decreases net income by $33,000; Company Z increases net income by $83,000.
  8. Stimpson Corporation buys cameras for $500 apiece and then sells each one for $1,200. During Year One, 9,000 units were sold. Each sale includes a one-year warranty. Stimpson estimates that 6 percent of the cameras will break (all during Year Two) and have to be fixed at an estimated cost of $190 each. In Year Two, no additional cameras are sold, but 590 cameras actually break but only cost $180 each to fix. What expense should Stimpson recognize for Year Two?

    1. $3,600
    2. $5,900
    3. $9,000
    4. $9,500
  9. The Greene Company sells appliances along with an embedded warranty. In Year One, the company recognizes a warranty expense of $54,000. In Year Two, the company has an actual expense that is different than $54,000. Under what condition will the company restate the number reported for Year One?

    1. Under no condition.
    2. If the original estimate was discovered to be too low.
    3. If the original estimate was not made by company officials in good faith.
    4. If the original estimate was discovered to be too high.
  10. The Knafo Company sells toaster ovens for $50 apiece. The company also planned to sell a one-year warranty with each purchase for $3. Company officials believe that 10 percent of all toaster ovens will break during Year Two and cost $7 each to fix. The company expects 40 percent of its customers to buy this extended warranty. At the last moment, company officials decide to give all customers a free one-year warranty to create customer loyalty. During Year One, the company sells 1,000 units. In Year Two, 11 percent of all toasters broke. Each repair cost $7. Because of the decision to give the warranty to all customers for free, the company will report a lower net income in Year One. How much lower will the net income figure be for Year One because of this decision?

    1. $298
    2. $400
    3. $700
    4. $1,200
  11. Use the information in problem 10 again. Because of the decision to give the warranty to all customers for free, the company will report a lower liability at the end of Year One. How much lower will the liability be at the end of Year One because of this decision?

    1. $500
    2. $700
    3. $900
    4. $1,200
  12. Use the information in problem 10 again. Because of the decision to give the warranty to all customers for free, the company will report a lower net income in Year Two. How much lower will the net income figure be in Year Two because of this decision?

    1. $320
    2. $468
    3. $648
    4. $962
  13. On January 1, Year One, Purple Company sues Yellow Company for $6 million. At the end of Year One, both companies think that the probable outcome of this lawsuit is a settlement for $170,000. They also believe that a settlement of $290,000 is reasonably possible while a settlement of $540,000 is possible but remote. In Year Two, the lawsuit is settled with Purple winning exactly $120,000. Which of the following is correct about the reporting for Year Two?

    1. Purple recognizes a loss of $50,000; Yellow recognizes a gain (a recovery) of $50,000.
    2. Purple recognizes a gain of $120,000; Yellow recognizes a gain (a recovery) of $50,000.
    3. Purple recognizes a gain of $120,000; Yellow recognizes a loss of $120,000.
    4. Purple recognizes a loss of $50,000; Yellow recognizes a loss of $120,000.
  14. Langston Corporation is being sued by a competitor for $1 million. At the end of the year, company officials believe that there is a 51 percent chance of a loss of $420,000 from this lawsuit. Which of the following statements is true?

    1. Under both U.S. GAAP and IFRS, a liability of $420,000 is recognized.
    2. Under U.S.GAAP (but not under IFRS), a liability of $420,000 is recognized.
    3. Under IFRS (but not under U.S. GAAP), a liability of $420,000 is recognized.
    4. Under both U.S. GAAP and IFRS, no liability is recognized at this time.
  15. Maxout Company sells computers. Customers have the option to buy an extended warranty that covers their computer for two years. To get the extended warranty, the customer must pay $200. Maxout expects every computer will have to be fixed during the warranty period at a cost of $100. What journal entry will Maxout make at the time the computer is purchased, assuming the customer buys the extended warranty?

    1. Figure 13.19

    2. Figure 13.20

    3. Figure 13.21

    4. Figure 13.22

  16. Sierra Inc. manufactures environmentally friendly appliances. It provides a four-year warranty as a standard part of each purchase. In Year One, Sierra sold 450,000 toasters. Past experience has shown that 4 percent of the toasters usually require repair at an average cost of $10 each. During Year One, Sierra actually spends $38,000 on repairs and during Year Two, Sierra spends another $65,000. What is the balance in the warranty liability account at the end of Year Two?

    1. $67,000
    2. $77,000
    3. $84,000
    4. $94,000
  17. The following figures appear on LaGrange’s financial statements for the most recent fiscal year:

    Cost of goods sold $1,960,000
    Beginning inventory 238,000
    Ending inventory 278,000
    Accounts payable 182,000

    What is the age of this company’s accounts payable?

    1. 33.2 days
    2. 33.9 days
    3. 34.7 days
    4. 35.3 days

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while returning a book at the library, your roommate poses this question: “My parents came up with this great idea. They started selling gift cards this year right before Christmas. A lot of our older customers bought bunches of these cards to give to their children and grandchildren as presents. This was one of my parent’s best ideas ever; the money really poured into each of the shops. However, when I asked my parents about their net income for the year, they said that these sales had not affected net income. That makes absolutely no sense. They sold thousands of gift cards for ice cream and got real money. How could their net income have not gone up through the roof?” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has expanded and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We are about to start selling a new line of office equipment. We really want to get our customers to consider this merchandise. We have been thinking about giving a free two-year warranty with each purchase. That eliminates risk and makes people feel more comfortable about the purchase. However, one of the other owners wants to charge a small amount for this warranty just so that we can make a small profit. We still take away the risk, but we also increase our net income. The decision is important, so I want to understand: how will each of these two alternatives affect the way our company looks on its balance sheet and income statement?” How would you respond?

Problems

  1. Knockoff Corporation sells a videogame unit known as the Gii. During the month of December, the following events occur. Prepare any necessary journal entries and adjusting entries that Knockoff should record.

    1. Knockoff purchased $300,000 of inventory on account.
    2. The company incurs salary expense of $45,000, although employees will not be paid until the beginning of January. The company also owes an additional $7,000 to the government for payroll taxes.
    3. Knockoff determines that it owes the IRS $120,000 in income taxes for this year.
    4. A retail customer places an advance order for Giis and pays Knockoff $23,000. The Giis will be shipped in January.
    5. Knockoff owes a local bank $4,000 in interest on a loan.
    6. Knockoff rents a warehouse of $3,000 per week. No payments were made for the last three weeks of the year.
  2. OK Corporation sells gift cards in various denominations. The company likes to sell these cards because cash is collected immediately, but a certain percentage will never be redeemed for merchandise. On December 1, Year One, OK reported a balance in unearned revenue of $728,000 from the sale of gift cards.

    1. During December, OK sold an additional $578,000 in gift cards. Prepare this journal entry.
    2. During December, gift cards totaling $327,000 were redeemed to purchase inventory that had originally cost OK $190,000. Prepare these journal entries. Assume OK uses a perpetual inventory system.
    3. On December 31, OK’s accountant determines that 3 percent of the outstanding gift cards will never be redeemed because they have expired. Prepare a journal entry if necessary.
    4. What is the amount reported by OK on its December 31, Year One, balance sheet for unearned revenues?
  3. In Year One, the Yankee Corporation allegedly damaged the Sox Corporation. The Sox Corporation sued the Yankee Corporation for $1 million. At the end of Year One, both companies believed that an eventual payment of $300,000 by Yankee was probable, but a payment of $480,000 was reasonably possible. The case moved through the court system rather slowly, and at the end of Year Two, both companies had come to believe that an eventual payment of $340,000 by Yankee was now probable, but a payment of $700,000 was reasonably possible. In Year Three, this lawsuit is settled for $275,000 in cash.

    1. Determine the income effect to be reported by each company for each of these three years.
    2. Discuss how the financial reporting might be different if these companies were reporting according to IFRS instead of U.S. GAAP.
  4. Whalens Corporation buys large screen televisions for $500 each and sells them for $1,200 each. During Year One, 8,000 sets were bought and sold for cash. Whalens estimates that 1 percent of all sets will break during Year Two. Company officials believe they will cost $150 to fix. Whalens offers a one-year warranty for $40. A total of only 700 customers choose to buy the warranty. In Year Two, nine of the televisions under warranty break but cost only $140 to repair.

    1. At the end of Year One, what revenue and expense should Whalens report in connection with this warranty?
    2. At the end of Year Two, what revenue and expense should Whalens report in connection with this warranty?
  5. The Haynesworth Corporation is sued for $10 million in Year One. At the end of Year One, company officials believe a loss is only remote. However, the case drags on so that by the end of Year Two, company officials believe it is reasonably possible that a loss of $2 million could be incurred. The case goes to trial during Year Three, and company officials now believe that a loss of $3 million is probable. The case ends on April 23, Year Four, when the Haynesworth Corporation agrees to pay $2.6 million in cash to settle all claims.

    Indicate the amount of loss that will be reported by the Haynesworth Corporation in each of these four years.

  6. On January 1, Year One, the Atlanta Company sues the Seattle Company for $100 million for patent infringement. The case is expected to take years to settle. For each of the following independent situations, indicate the financial reporting to be made by each company.

    1. Both companies believe that Atlanta will probably win this case. However, both feel that estimating the amount of this loss is virtually impossible.
    2. Both companies believe that Atlanta will probably win this case. Both feel that Atlanta will probably win approximately $9 million, but a win as high as $46 million is reasonably possible.
    3. Both companies believe that a loss by Seattle of $53 million is reasonably possible.
    4. Atlanta officials believe that their company will probably win $44 million whereas Seattle officials believe that their company will probably lose $8 million.
  7. Ingalls Company is a jeweler located in a shopping mall in a midsize city in Ohio. During December of Year One, an unfortunate accident occurs. Mrs. Rita Yeargin trips over a giant, singing Rudolph set up by the mall management and goes sprawling into Ingalls’s store where she cracked her head on a display case. She spent several days in the hospital with a sprained ankle, severely bruised elbow, and a concussion. Prior to the end of the year, Mrs. Yeargin’s lawyer files papers to sue both the mall management company and Ingalls for $1,000,000. Ingalls’s insurance company informs the jeweler that the store policy does not cover accidents involving giant, singing Rudolphs. Ingalls’s attorney is unsure as to what a jury might do in this case because of the unusual nature of the event. He estimates that a loss of $800,000 is probable but that Ingalls will only be liable for 20 percent of that amount since the Rudolph actually belonged to the mall.

    1. Determine if Ingalls needs to record a journal entry on December 31, Year One, and if so, prepare that entry.
    2. Ingalls pays Mrs. Yeargin $97,000 on July 11, Year Two, to settle this claim. Make the journal entry for Ingalls at that time.
  8. Sadler Corporation produces lawnmowers. The lawnmowers are sold with a free three-year warranty. During Year One, Sadler sold 20,000 lawnmowers for $10 million in cash. These lawnmowers cost $5,800,000. Sadler’s accountant estimates that 10 percent of the units will need to be repaired at some point over the next three years at an average cost of $37 per lawnmower.

    1. Make the journal entry to record the sale of the lawnmowers in Year One if a perpetual inventory system is used.
    2. Make the journal entry (if any is needed) to record the warranty.
    3. During Year Two, Sadler spends $24,000 to repair a number of these lawnmowers. Prepare the necessary journal entry.
    4. At the end of Year Two, Sadler’s accountant reevaluates the warranty. The accountant suspects that the actual warranty liability will be higher than her original estimate. She now believes that 12 percent of the original sales will eventually result in a repair (but still at $37 each). Make the necessary adjusting entry.
  9. The Eyes Have It sells custom eyewear during Year One that come with an embedded warranty. If the glasses break during Year Two, they will be fixed for free. Customers may also purchase an extended warranty that covers Year Three. During Year One, the company sold 55,000 pairs of eyeglasses for $1,000,000. Customers who purchased 40,000 of those pairs also purchased the Year Three extended warranty. The extended warranty brought in additional cash of $200,000. The company expects that 6 percent of the glasses will break during Year Two, and another 8 percent will break during Year Three. Each repair will cost $20 to fix.

    1. Record the embedded warranty in Year One.
    2. Record the sale of the extended warranties in Year One.
    3. Assume that during Year Two the company spends $70,000 to repair glasses for these customers. Prepare the necessary journal entry.
    4. Assume that during Year Three the company spends another $102,000 to repair glasses that are covered under the extended warranty. Prepare the necessary journal entry.
  10. During Year One, Company A and Company Z both sell 1,000 computers for $1,000 each in cash. Company A provides a one-year warranty to its customers for free. Company Z sells a one-year warranty to all of its customers for $50 each. Both companies expect 5 percent of the computers to break and cost $600 each to repair. In Year Two, both companies actually have 6 percent of these computers break. However, the required cost to fix each one was only $550.

    1. In financial reporting for Year One, which company will report the highest amount of net income? What will be the difference in the two reported amounts?
    2. In financial reporting for Year Two, which company will report the highest amount of net income? What will be the difference in the two reported amounts?
  11. In several past chapters, we have met Heather Miller, who started her own business, Sew Cool. The following are the financial statements for December. To calculate age of accounts payable, assume that beginning inventory on 6/1/20X8, when Sew Cool started business, was zero. Also, assume that Sew Cool was only in business for 210 days.

    Figure 13.23 Sew Cool Financial Statements

    Figure 13.24

    Figure 13.25

    Based on the financial statements determine the following:

    1. Current ratio
    2. Age of accounts payable

Comprehensive Problem

This problem will carry through several chapters, building in difficulty. It allows students to continually practice skills and knowledge learned in previous chapters.

In Chapter 12 “In a Set of Financial Statements, What Information Is Conveyed about Equity Investments?”, financial statements for December were prepared for Webworks. They are included here as a starting point for the required recording for January.

Figure 13.26 Webworks Financial Statements

Figure 13.27

Figure 13.28

The following events occur during January:

  1. Webworks starts and completes seven more sites and bills clients for $4,500.
  2. Webworks purchases supplies worth $100 on account.
  3. At the beginning of January, Webworks had fourteen keyboards costing $113 each and twenty flash drives that had been written down to $5 each in December due to obsolescence. Webworks uses periodic FIFO to cost its inventory.
  4. On account, Webworks purchases sixty-five keyboards for $117 each and ninety of the new flash drives for $20 each.
  5. Webworks pays Nancy Po (company employee) $775 for her work during the first three weeks of January.
  6. Webworks writes off an account receivable from October in the amount of $150 because collection appears unlikely.
  7. Webworks receives $450 in advance to design a Web site for a local salon. Work will not begin on the Web site until February.
  8. Webworks sells sixty keyboards for $9,000, all twenty of the old flash drives for $100 and eighty of the new flash drives for $2,400 cash.
  9. During January, Webworks receives notice that one of its former clients is not happy with the work performed. When Webworks refuses to refund the client’s money, the client decides to sue for what he paid plus damages for his “pain and suffering,” which comes to $5,000. An attorney friend of Leon Jackson’s (the owner of the business) mother believes that the suit is without merit and that Webworks probably will not have to pay anything.
  10. Webworks collects $5,000 in accounts receivable.
  11. During January, Webworks sells all of its stock in XYZ Company for $8 per share. Webworks had originally purchased sixty shares for $5 and they were selling for $6 per share on the last balance sheet date.
  12. Webworks pays $200 for advertising that will run over the next two months.
  13. Webworks pays off its salaries payable from December.
  14. Webworks purchased 175 shares of QRS Company for $10 per share. Webworks considers this an available-for-sale security.
  15. Webworks pays off $9,000 of its accounts payable.
  16. Webworks pays Leon Jackson a salary of $2,000.
  17. Webworks prepays $600 for rent for the months of January, February, and March.
  18. QRS Company pays Webworks a dividend of $30.
  19. Webworks pays taxes of $1,000 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for January.
    4. Prepare adjusting entries for the following and post them to your T-accounts.
  20. Webworks owes Nancy Po $200 for her work during the last week of January.
  21. Leon’s parents let him know that Webworks owes $320 toward the electricity bill. Webworks will pay them in February.
  22. Webworks determines that it has $40 worth of supplies remaining at the end of January.
  23. Prepaid rent should be adjusted for January’s portion.
  24. Prepaid advertising should be adjusted for January’s portion.
  25. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  26. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method.
  27. The license agreement should be amortized over its one-year life.
  28. QRS Company is selling for $9 per share on January 31.
  29. Record cost of goods sold.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements for January.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in Barnes & Noble. The partner is aware that Barnes & Noble sells a lot of gift cards. The partner is curious as to the size of the changes in that liability balance because the partner feels that increases and decreases will signal similar changes in revenue balances for the following year. The partner is also interested in knowing how much profit Barnes & Noble makes from breakage (gift cards that are never redeemed). The partner asks you to look at the 2011 financial statements for Barnes & Noble by following this path:

  • Go to http://www.barnesandnoble.com.
  • At the very bottom of this screen, click on “Investor Relations.”
  • On the next screen, scroll to the bottom and click on “Annual Reports.”
  • On the next screen, in the center, click on “2011 Annual Report” to download.
  • Go to page 38 and read the paragraph under “Gift Cards.”
  1. What was the amount of gift card liability at the end of the previous year and at the end of the current year? What was the percentage change?
  2. What was the amount of net income reported for the most recent year as a result of breakage (gift cards that were not redeemed)?

Chapter 12: In a Set of Financial Statements, What Information Is Conveyed about Equity Investments?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 12 “In a Set of Financial Statements, What Information Is Conveyed about Equity Investments?”.

12.1 Accounting for Investments in Trading Securities

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Realize that the financial reporting of investments in the ownership shares of another company depends on the purpose of the acquisition.
  2. Explain the characteristics of investments that are classified as trading securities.
  3. Account for changes in the value of investments in trading securities and understand the rationale for this handling.
  4. Record dividends received from investments that are classified as trading securities.
  5. Determine the gain or loss to be recorded on the sale of a trading security.

The Reasons Why One Company Buys Ownership Shares of Another

Question: Businesses frequently acquire ownership shares (often referred to as equity or capital shares) of other companies. On September 30, 2011, Microsoft disclosed that it held “equity and other investments” reported at nearly $8.6 billion. Many such investments are only made to acquire a small percentage of the ownership. However, that is not always the case. In April, 2011, Johnson & Johnson announced the $21.3 billion purchase of Swiss medical device maker Synthes Inc. Whether a few shares are bought, or the entire company is bought, such investments offer many potential benefits. What are the most common reasons for one company to buy the ownership shares of another company?

 

Answer: Potentially, many benefits can accrue from obtaining shares of the capital stock issued by another business. Interestingly, the specific method of financial reporting depends on the owner’s purpose for holding such investments. Thus, the accounting process here is quite unique. The reporting of most assets (such as inventory and equipment) does not vary because of the rationale for making the purchase and then retaining the property. In contrast, the accounting process used to report the ownership of stock in another company falls within one of several methods based solely on the reason for the investment.

Companies frequently find that they are holding excess cash not needed at the moment for operating purposes. Such money can be temporarily invested to increase net income. Traditional savings accounts or money market funds offer only very low returns. Company officials often seek greater profit by using surplus money to buy the ownership shares of other organizations. The hope is that the market price of these shares will appreciate in value and/or dividends will be received before the cash is needed for operations. Such investments can be held for a few days (or even hours) or many years. Although earnings can improve through this strategy, the buyer does face additional risk. Share prices do not always go up. They can also decline in value, resulting in losses for the investor.

When equity shares are bought solely as a way to store cash and increase profits, the investor has no desire to influence or control the decisions of the other company. That is not the reason for the purchase; the ownership interest is much too small.

Investors, though, may also embrace a strategy of acquiring enough shares to gain some degree of influence over the other organization. Often, profitable synergies can be developed by having two companies connected in this way. For example, as of October 3, 2010, Starbucks Corporation held 39.9 percent of the outstanding stock of Starbucks Coffee Japan LtdStarbucks does not own a sufficient number of shares to controlAccording to U.S. GAAP, it exists when one company owns more than 50 percent of the outstanding common shares of another company so that the parent can direct all decision making; for external reporting purposes, the financial information of both companies must be consolidated to form a single set of financial statements. the operations of the Japanese company, but it certainly can apply significant influence if it so chooses.

Finally, as in the acquisition of Synthes by Johnson & Johnson, the investor may seek to obtain a controlling interest in the other company (in U.S. GAAP that is viewed as being over 50 percent of the outstanding capital stock). In many cases, the parent company chooses to buy 100 percent ownership of the other business to gain complete control. Such acquisitions are common as large companies attempt to (a) move into new industries or geographical areas, (b) become bigger players in their current markets, (c) gain access to valuable assets, or (d) eliminate competitors. Many smaller companies are started by entrepreneurs with the specific hope that success will attract acquisition interest from a larger organization. Often, significant fortunes are earned by the original owners as a result of the sale of their company to a bigger business.

Trading Securities

Question: As can be seen in the previous answer, several different reasons exist for buying capital stock. Applicable accounting rules can best be demonstrated by focusing on one of these types of investments at a time.

Assume that Valente Corporation is holding $25,000 in cash that it will not need for several weeks. This money is currently in a money market fund earning only a 1 percent annual rate of return. In hopes of generating a higher profit, the president of Valente has studied the financial statements of Bayless Corporation, a company with capital stock trading on the New York Stock Exchange for $25 per share. By November 30, Year One, the president has come to believe that Bayless stock will make a rather significant jump in market price in the near future. Consequently, Valente uses the $25,000 to acquire one thousand shares of stock in Bayless that will be held for only a few weeks or months. How does a company report an equity investment that is bought with the expectation that the shares will be sold shortly after the purchase is made?

 

Answer: If management intends to sell the equity shares of another company shortly after buying them, the purchase is classified on the balance sheet as an investment in trading securitiesClassification of investments in stocks and bonds when management’s intentions are to sell them quickly in the near term; they are reported as assets on the balance sheet at fair value with all changes in value affecting net income.. On the acquisition date, as shown in Figure 12.1 “Purchase of Ownership Shares Classified as Trading Securities”, the asset is recorded by Valente at historical cost.

Figure 12.1 Purchase of Ownership Shares Classified as Trading Securities

As an owner, even if the shares are only held for a short time, Valente might receive a cash dividend from Bayless. Many companies distribute dividends to their stockholders periodically as a way of sharing a portion of any income that has been earned.

Assume that Bayless has been profitable and, as a result, a $0.20 per share cash dividend is declared by its board of directors and paid in December, Year One. Valente receives $200 of this dividend ($0.20 per share × 1,000 shares), which is reported as revenue on the owner’s Year One income statement. The journal entry is presented in Figure 12.2 “Receipt of Dividend from Investment in Stock”.

Figure 12.2 Receipt of Dividend from Investment in Stock

Because of the short-term nature of this investment, Valente might sell these shares prior to the end of Year One. The purchase of Bayless stock was made anticipating a quick sale. Consequently, a gain is reported if more than $25,000 is received, whereas a loss results if the shares are sold for less than $25,000. Such gains and losses appear on the owner’s income statement when created by the sale of a trading security.

The Value of Trading Securities at Year’s End

Question: The accounting process for trading securities becomes more complicated if Valente continues to own this investment in Bayless at year end. Should equity shares held as a trading security be reported on the owner’s balance sheet at historical cost or current fair value? Which reporting provides the most helpful information to outside decision makers?

 

Answer: U.S. GAAP requires investments in trading securities to be reported on the owner’s balance sheet at fair value. Therefore, if the shares of Bayless are worth $28,000 at December 31, Year One, Valente must adjust the reported value from $25,000 to $28,000 by reporting a gain as shown in Figure 12.3 “Shares of Bayless (a Trading Security) Adjusted to Fair Value at End of Year One”.

Figure 12.3 Shares of Bayless (a Trading Security) Adjusted to Fair Value at End of Year One

The gain here is labeled as unrealizedA gain or loss created by an increase or decrease in the value of an asset although not yet finalized by a sale. to indicate that the value of the asset has appreciated but no final sale has yet taken place. Therefore, the gain is not guaranteed; the value might go back down before the shares are sold. However, the $3,000 unrealized gain is reported on Valente’s Year One income statement so that net income is affected.

Test Yourself

Question:

James Attenborough is studying the financial statements published for the Hawthorne Roberts Corporation. This company owns shares in Microsoft and several other companies. Consequently, it reports an investment in trading securities account on its year-end balance sheet as an asset with a balance of $18,765. What does that figure represent?

  1. It is impossible to tell without reading the notes to the financial statements.
  2. The $18,765 was the historical cost of these shares.
  3. The $18,765 is the fair value of the shares on the balance sheet date.
  4. The $18,765 is the lower of the cost or market value of these shares at the end of the year.

Answer:

The correct answer is choice c: The $18,765 is the fair value of the shares on the balance sheet date.

Explanation:

Investments in trading securities are held for a relatively quick sale. They are always reported at fair value regardless of whether that figure is above or below the cost of acquisition. Fair value is easy to determine and the company knows that it can get that amount on the balance sheet date.

Reporting Trading Securities at Fair Value

Question: The reporting demonstrated above for an investment in a trading security raises a theoretical question that has long been debated in financial accounting. Is recognizing a gain in the value of a trading security (or a loss if the stock price has declined) on the owner’s income statement appropriate before an actual sale takes place? In this illustration, for example, a $3,000 gain is reported, but the value of these shares might suddenly plummet and eliminate that gain prior to a sale. The gain might never be received. In previous chapters, assets such as buildings and inventory were never adjusted to fair value unless impairment had taken place. Why is an investment in a trading security always reported at fair value regardless of whether that value is above or below historical cost?

 

Answer: Changes in the value of trading securities are recognized and the resulting gains or losses are included within current net income for several reasons:

  • The Bayless shares sell on a stock exchange. Thus, the reported value of $28,000 can be objectively determined. It is not an estimated amount subject to manipulation as is the fair value of assets such as buildings and inventory.
  • The stock can be sold immediately; Valente does not even have to find a buyer. The stock exchange provides a workable mechanism to create a sale whenever the owner wants to liquidate the investment. No question exists that these shares can be sold at any time. Once again, the same assertion cannot be made for assets such as buildings and inventory.
  • As a trading security, a sale is anticipated in the near term. The owner does not plan to hold the stock for a long period of time. Further changes in value can certainly take place but are less likely to be severe. The shortness of time limits the chance of radical fluctuations in value after the balance sheet date.

For these reasons, U.S. GAAP requires that investments in trading securities be reported on the owner’s balance sheet at fair value ($28,000 in this example). Therefore, Valente will report both the dividend revenue of $200 and the unrealized gain of $3,000 on its Year One income statement.

If, instead, the fair value at year-end had been only $21,000, a $4,000 unrealized loss appears on Valente’s income statement to reflect the decline in value ($25,000 historical cost dropping to $21,000 fair value).

Test Yourself

Question:

During Year One, Hancock Corporation buys 2,000 shares of Waltz Inc. for $34 per share. Hancock appropriately records this acquisition as an investment in trading securities because it plans to make a sale in the near future. In December of Year One, Waltz pays a $1 per share cash dividend to its owners. On the last day of December, the stock is selling on a stock exchange for $39 per share. What is the impact of these events on the income reported by Hancock for Year One?

  1. No effect
  2. Increase of $2,000
  3. Increase of $10,000
  4. Increase of $12,000

Answer:

The correct answer is choice d: Increase of $12,000.

Explanation:

The dividend that is received ($2,000 or $1.00 per share × 2,000 shares) is reported as revenue by the recipient (Hancock). In addition, because these shares are classified as trading securities, the change in value this year also impacts net income. The price of the stock went up $5 per share ($39 less $34) so that Hancock reports a gain of $10,000 ($5 per share × 2,000 shares). Total increase in income reported by Hancock is $12,000 ($2,000 plus $10,000).

The Sale of a Trading Security

Question: In this ongoing illustration, Valente Corporation bought one thousand shares of Bayless Corporation which it planned to sell in a relatively short period of time. At the end of Year One, this trading security was adjusted from the historical cost of $25,000 to its fair value of $28,000. The $3,000 unrealized gain was reported within net income on the Year One income statement.

Assume that these shares are sold by Valente on February 3, Year Two, for $27,000 in cash. What financial reporting is appropriate when an investment in trading securities is sold in a subsequent period? What effect does this final transaction have on reported income?

 

Answer: Following the Year One adjustment, this investment is recorded in the general ledger at the fair value of $28,000 rather than historical cost. When eventually sold, any difference between the sales price and this carrying amount is recorded as a gain or a loss on the Year Two income statement.

Because the sales price of these shares ($27,000) is less than the balance now being reported ($28,000), recognition of a $1,000 loss is appropriate, as can be seen in Figure 12.4 “Sale of Shares of Bayless (a Trading Security) for $27,000 in Year Two”. This loss reflects the drop in value of the shares that took place during Year Two.

Figure 12.4 Sale of Shares of Bayless (a Trading Security) for $27,000 in Year Two

This investment was originally bought for $25,000 and later sold for $27,000 so an overall gain of $2,000 was earned. For reporting purposes, this income effect is spread between the two years of ownership. A gain of $3,000 was recognized in Year One to reflect the appreciation in value during that period of time. Then, in Year Two, a loss of $1,000 is reported because the stock price fell by that amount prior to being sold.

Investments in trading securities are always shown on the owner’s balance sheet at fair value. The gains and losses reported in the income statement will parallel the movement in value that took place each period.

Test Yourself

Question:

Late in Year One, a company buys one share of a publicly traded company for $75. This investment is reported as a trading security because the owner plans to sell the stock in the near future. At the end of Year One, this share is only worth $62. However, early in Year Two, the stock price soars to $80 and the stock is sold. A $2 cash dividend is also received by the owner in January of Year Two. What is the reported income effect of this ownership?

  1. No change in income in Year One but a $5 increase in Year Two.
  2. No change in income in Year One but a $7 increase in Year Two.
  3. Net income is reduced $13 in Year One but an $18 increase in Year Two.
  4. Net income is reduced $13 in Year One but a $20 increase in Year Two.

Answer:

The correct answer is choice d: Net income is reduced $13 in Year One but a $20 increase in Year Two.

Explanation:

As a trading security, the $13 drop in value in Year One ($75 less $62) is reported as a loss on the owner’s income statement. Then, the $18 rise in value in Year Two ($80 less $62) increases net income. In addition, the $2 dividend increases the Year Two income reported by the owner bringing it up to $20.

Key Takeaway

Many companies acquire the equity shares of other companies as investments. The applicable accounting procedures depend on the purpose for the ownership. If the stock is only to be held for a short period of time, it is labeled a trading security. The investment is then adjusted to fair value whenever financial statements are to be produced. Any change in value creates a gain or loss that is reported within net income because fair value is objectively determined, the shares can be liquidated easily, and a quick sale is anticipated before a significant change in fair value is likely to occur. Dividends received by the owner are recorded as revenue. Whenever trading securities are sold, only the increase or decrease in value during the current year is reported within net income since earlier changes have already been reported in that manner.

12.2 Accounting for Investments in Securities That Are Classified as Available-for-Sale

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Identify the types of investments classified as available-for-sale.
  2. Record the receipt of dividends from an investment that is viewed as available-for-sale.
  3. Explain the financial reporting of changes in the fair value of investments in available-for-sale securities.
  4. Calculate the gain or loss to be reported when available-for-sale securities are eventually sold.
  5. Understand the need for reporting comprehensive income as well as net income.
  6. Explain the adjustment made to net income in order to arrive at comprehensive income.

Reporting Available-For-Sale Investments

Question: Not all investments in stock are bought for quick sale. Assume that Valente Corporation bought one thousand shares of Bayless Corporation for $25 each in Year One but does not anticipate selling this investment in the near term. Company officials intend to hold these shares for the foreseeable future until the money is clearly needed. Although the stock could be sold at any time, the president of Valente believes the investment might well be retained for years. During Year One, a $200 cash dividend is received from the Bayless shares. At the end of that period, the stock is selling for $28 per share. How does the decision to hold equity shares for an extended period of time impact the financial reporting process?

 

Answer: Valente does not anticipate a quick sale of its investment in Bayless. Because Valente’s intention is to retain these shares for an indefinite period, they will be classified on the company’s balance sheet as an investment in available-for-sale securitiesAccounting classification for investments in stocks and bonds when management’s intentions are to retain them for an indefinite period; they are reported on the balance sheet at fair value although unrealized gains and losses are included in stockholders’ equity and not within net income. rather than as trading securities. Despite the difference in the plan for holding these shares, they are—once again—recorded at historical cost when acquired, as shown in Figure 12.5 “Purchase of Ownership Shares Classified as Available-for-Sale Securities”.

Figure 12.5 Purchase of Ownership Shares Classified as Available-for-Sale Securities

The receipt of the dividend is also reported in the same manner as before with the dividend revenue increasing Valente’s net income. No difference is created between the accounting for trading securities and accounting for available-for-sale securities as a result of a dividend.

Figure 12.6 Receipt of Dividend from Investment in Available-for-Sale Securities

The difference in reporting begins at the end of the year. U.S. GAAP requires available-for-sale investments to be included on the investor’s balance sheet at fair value (in the same manner as trading securities). As before, this adjustment to fair value creates an unrealized gain of $3,000, as is reflected in Figure 12.7 “Shares of Bayless (an Available-for-Sale Security) Are Adjusted to Fair Value at End of Year One”. However, reported net income is not affected as it was with the investment in the trading security.

Figure 12.7 Shares of Bayless (an Available-for-Sale Security) Are Adjusted to Fair Value at End of Year One

Accumulated Other Comprehensive Income

Question: Based on the previous discussion, an immediate question is obvious: If the $3,000 unrealized gain shown in Figure 12.7 “Shares of Bayless (an Available-for-Sale Security) Are Adjusted to Fair Value at End of Year One” is not presented on the income statement, where is that amount reported by the owner? How are changes in the fair value of available-for-sale securities reported?

 

Answer: Because no sale is anticipated in the near term, the fair value of available-for-sale shares will possibly go up and down numerous times before being sold. Hence, the current gain is not viewed as “sure enough.” As a result of this uncertainty, a change in the owner’s reported net income is not considered appropriate.

Instead, any unrealized gain (or loss) in the value of an investment that is classified as available-for-sale is reported within the stockholders’ equity section of the balance sheet. The figure is listed either just above or below the retained earnings account. A few other unrealized gains and losses are handled in this manner and are combined and reported as accumulated other comprehensive incomeA section of the stockholders’ equity of a balance sheet where unrealized gains and losses on available-for-sale securities (as well as a few other specified gains and losses) are shown rather than being presented on the reporting company’s income statement. as shown in Figure 12.8 “Stockholders’ Equity Including Accumulated Other Comprehensive Income”.

Figure 12.8 Stockholders’ Equity Including Accumulated Other Comprehensive Income

Consequently, the primary difference in the financial accounting for trading securities and available-for-sale securities is in the placement of unrealized gains and losses from changes in value:

  • Changes in the value of trading securities are reported in the income statement.
  • Changes in the value of available-for-sale securities are shown in stockholders’ equity and not net income.

The described procedures were first created in 1993 and have been used since that time. Interestingly, in 2007, FASB passed a rule that allows companies to elect to report available-for-sale investments as trading securities. This option must be selected when the investment is purchased. Thus, if that election is made, the $3,000 unrealized gain is reported on the income statement despite the intention to hold the securities for an indefinite period. This is another example of accounting rules that are not as rigid as sometimes perceived.

Test Yourself

Question:

Company A buys shares of a well-known company in Year One for $130,000. Company officials plan to hold this investment for only a short period of time so that it is classified as a trading security. Coincidentally, Company B makes the same investment at the same time for the same cost. However, Company B officials expect to hold these shares indefinitely. Company B reports this investment as available-for-sale and does not elect to report it in the same manner as a trading security. Both companies continue to hold their investments at the end of the year when they are each worth $144,000. Which of the following is not true?

  1. Both companies will report their investment at $144,000.
  2. Net income will increase more for Company A than for Company B because of these investments.
  3. Company A reports other accumulated comprehensive income on the December 31, Year One, balance sheet of $14,000.
  4. Company B reports other accumulated comprehensive income on the December 31, Year One, balance sheet of $14,000.

Answer:

The correct answer is choice c: Company A reports other accumulated comprehensive income on the December 31, Year One, balance sheet of $14,000.

Explanation:

Both companies report the asset as $144,000, its fair value at the end of the year. Company A views these shares as trading securities so that the increase in value of $14,000 is reported as an unrealized gain in net income. However, Company B has classified the investment as available-for-sale. Thus, the $14,000 unrealized gain is not shown within net income but, rather, in stockholders’ equity as “other accumulated comprehensive income.”

The Sale of Available-For-Sale Securities

Question: Assume that Valente did not choose to report the available-for-sale investment as a trading security but rather by means of the traditional approach. Thus, the $3,000 unrealized gain created by the appreciation of value is reported within stockholders’ equity at the end of Year One. In Year Two, these shares are sold on the stock exchange for $27,000. What reporting is made at that time? How is the eventual sale of investments that are classified as available-for-sale securities reported?

 

Answer: When available-for-sale securities are sold, the difference between the original cost ($25,000) and the selling price ($27,000) appears as a realized gain (or loss) on the owner’s income statement. Because no change in net income was reported in the previous year, this entire amount has to be recognized at the date of sale. Having presented the unrealized gain within stockholders’ equity in Year One, the change in value only touches net income when sold.

However, mechanical complexities now exist. The investment has been adjusted to a $28,000 carrying amount, and a $3,000 unrealized gain still remains within stockholders’ equity. As a balance sheet account, this $3,000 figure is not closed out at the end of Year One. Therefore, when the investment is sold, both the $28,000 asset and the $3,000 unrealized gain must be removed. The net amount mirrors the $25,000 historical cost of these shares. By eliminating the previous gain in this manner, the asset is brought back to the original $25,000. Thus, as shown in Figure 12.9 “Sale of Available-for-Sale Security in Year Two”, the appropriate realized gain of $2,000 is recognized. The shares were bought for $25,000 and sold for $27,000, and the previous unrealized gain is removed.

Figure 12.9 Sale of Available-for-Sale Security in Year Two

Test Yourself

Question:

Company A buys ownership shares of a well-known company for $68,000 in Year One and classifies the asset as an investment in trading securities. Company B also buys shares of this company on the same date for $68,000. However, the investment is reported by this owner as available-for-sale. Company B does not elect to report this investment in the same manner as a trading security. Both investments are worth $70,000 at the end of Year One. Both investments are sold in Year Two for $60,000. Which of the following is true?

  1. Company B reports a bigger gain on its income statement in Year One than does Company A.
  2. Company B reports a bigger loss on its income statement in Year Two than does Company A.
  3. Company A reports a bigger loss on its income statement in Year One than does Company B.
  4. Company A reports a bigger loss on its income statement in Year Two than does Company B.

Answer:

The correct answer is choice d: Company A reports a bigger loss on its income statement in Year Two than does Company B.

Explanation:

Company A reports a trading security; the $2,000 increase in value is an income statement gain in Year One. The $10,000 drop in value is an income statement loss in Year Two. Because Company B reports these shares as available-for-sale, no income effect is recognized in Year One. In Year Two, the $8,000 difference between cost and amount received is a loss on the income statement. The gain reported by Company A is larger in Year One but the loss reported by Company A is larger in Year Two.

The Reporting of Comprehensive Income

Question: In Year One, Valente’s investment in the shares of Bayless Corporation rose in value by $3,000. As discussed earlier, if those securities are classified as available-for-sale, the unrealized gain does not impact reported net income but, rather, stockholders’ equity. This handling is justified because a number of additional changes in value (both increases and decreases) are likely to take place prior to the eventual sale of the investment.

As a result, the net income figure reported by Valente seems a bit misleading. It does not include the increase in the reported worth of this asset. Are decision makers well-served by an income figure that omits certain gains and losses? Assume, for example, that Valente reports total net income for Year One of $80,000. This figure includes no part of the $3,000 unrealized gain. What reporting is necessary to help investors and creditors understand the impact on income of a change in value when investments are labeled as available-for-sale?

 

Answer: As noted, changes in the value of available-for-sale securities create unrealized gains or losses that appear in the stockholders’ equity section of the balance sheet but not in net income. The completeness of reported net income in such situations can be questioned.

To help decision makers better evaluate reporting companies with such unrealized items, a second income figure is presented that does include these gains or losses. The resulting balance, known as comprehensive incomeNet income plus any unrealized gains and less any unrealized losses that appear in stockholders’ equity rather than within net income., is shown within a company’s financial statements. In Figure 12.10 “Net Income Converted to Comprehensive Income”, by adding in the $3,000 change in fair value, Valente’s net income figure is adjusted to the more complete total.

Figure 12.10 Net Income Converted to Comprehensive Income

Decision makers can choose to emphasize one figure (net income) or another (comprehensive income) in their analysis of a reporting company. More appropriately, they can view these two figures as simply different ways to portray the results of the current year and make use of both.

Comprehensive income includes all changes in stockholders’ equity other than (a) amounts contributed by stockholders and (b) dividend distributions made to stockholders. Unrealized gains and losses on available-for-sale securities are common but several other unrealized gains and losses are also included in moving from net income to comprehensive income.

Sometimes comprehensive income makes a company appear more successful, sometimes less so. For example, for the year ended December 31, 2010, Yahoo! Inc. reported its net income as $1.245 billion. However, the financial picture seems improved by disclosure of comprehensive income for the period of $1.367 billion. Conversely, The Dow Chemical Company reported net income for the same year of $2.321 billion but comprehensive income of only $1.803 billion.

Test Yourself

Question:

The Jelanizada Company reports revenue of $800,000 in Year One along with expenses of $700,000. In addition, the company bought shares of a publicly held company for $50,000 that was worth $70,000 by year’s end. This investment was reported as available-for-sale. Which of the following is true?

  1. Jelanizada should report net income for Year One of $80,000.
  2. Jelanizada should report net income for Year One of $120,000.
  3. Jelanizada should report comprehensive income for Year One of $100,000.
  4. Jelanizada should report comprehensive income for Year One of $120,000.

Answer:

The correct answer is choice d: Jelanizada should report comprehensive income for Year One of $120,000.

Explanation:

As an investment in an available-for-sale security, the $20,000 increase in value is reported as a gain in other accumulated comprehensive income in the stockholders’ equity section of the balance sheet. Net income is revenue minus expenses or $100,000 ($800,000 less $700,000). The gain, though, must then be included in arriving at a more inclusive comprehensive income figure of $120,000 (net income of $100,000 plus gain of $20,000).

Key Takeaway

Investments in equity securities are often held by the owner for an indefinite period of time. As such, the asset is classified as available-for-sale and shown at fair value each period. Any change in the reported amount is not included in net income but is rather listed within accumulated other comprehensive income in the stockholders’ equity section of the balance sheet. However, dividends that are received from the investment are reported as revenue and do impact the computation of net income. When eventually sold, the difference between the original cost of the securities and the proceeds received is reported as a gain or loss shown within net income. Because the periodic changes in value are not factored into the calculation of net income, they are included in the calculation of comprehensive income. Thus, both net income and comprehensive income are reported to decision makers to provide them with a better understanding of the impact of these unrealized gains and losses.

12.3 Accounting for Investments by Means of the Equity Method

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Describe the theoretical criterion for applying the equity method to an investment in stock and explain the practical standard that is often used.
  2. Compute the amount of income to be recognized when using the equity method and make the journal entry for its recording.
  3. Understand the handling of dividends that are received when the equity method is applied and make the journal entry.
  4. Indicate the impact that a change in fair value has on the reporting of an equity method investment.
  5. Prepare the journal entry to record the sale of an equity method security.

The Need to Apply the Equity Method

Question: Not all investments in capital stock are made solely for the possibility of gaining dividends and share price appreciation. As mentioned earlier, Starbucks holds 39.9 percent ownership of Starbucks Coffee Japan Ltd. The relationship between those two companies is different. The investor has real power; it can exert some amount of authority over the investee. Starbucks owns a large enough stake in Starbucks Coffee Japan Ltd. so that operating and financing decisions can be influenced. When one company holds a sizable portion of another company, is accounting for the investment as either an available-for-sale or trading security a reasonable approach?

 

Answer: The answer to this question depends on the size of ownership. As the percentage of shares being held grows, the investor gradually moves from having little or no authority over the investee to a position where significant influence can be exerted. At that point, for financial reporting purposes, the investment no longer qualifies as a trading security or an available-for-sale security. Instead, the shares are reported by means of the equity methodA method of reporting an investment in stock that is applied when the owner has the ability to exert significant influence on the decisions of an investee; in practice, it is used to report investments where 20 percent or more and less than or equal to 50 percent of the shares are held, unless evidence exists that significant influence does not exist.. The owner’s rationale for holding the investment has changed. The equity method views the connection between the two companies in an entirely different fashion. The accounting process applied by the investor is altered to more closely mirror this relationship.

The equity method is applied when the investor has the ability to apply significant influence to the operating and financing decisions of the investee. Unfortunately, the precise point at which one company gains that ability is impossible to ascertain. A bright line distinction simply does not exist. Although certain clues such as membership on the board of directors and the comparative size of other ownership interests can be helpful, the degree of influence is a nebulous criterion. When a question arises as to whether the ability to apply significant influence exists, the percentage of ownership can be used to provide an arbitrary standard.

According to U.S. GAAP, unless signs of significant influence are present, an investor owning less than 20 percent of the outstanding shares of another company reports the investment as either a trading security or available-for-sale security. In contrast, an investor holding 20 percent or more but less than or equal to 50 percent of the shares of another company is assumed to possess the ability to exert significant influence. Consequently, unless evidence is present that significant influence does not exist, the equity method is applied by the investor to report all investments in this 20–50 percent range of ownership.

Test Yourself

Question:

Howard Company acquires 26 percent of the outstanding stock of Birmington Bottling Company. Unfortunately, the Larito Company holds the other 74 percent of Birmington and pays no attention to the ideas and suggestions put forth by Howard. Which of the following is true about Howard’s reporting of this investment?

  1. The equity method should be applied because Howard holds 20–50 percent of the shares of Birmington Bottling.
  2. The equity method should not be applied because Howard only holds 26 percent of the shares of Birmington Bottling.
  3. The equity method should be applied because Howard has significant influence over Birmington Bottling.
  4. The equity method should not be applied because Howard does not have significant influence over Birmington Bottling.

Answer:

The correct answer is choice d: The equity method should not be applied because Howard does not have significant influence over Birmington Bottling.

Explanation:

Normally, if one company holds 20–50 percent of the outstanding stock of another company, significant influence is assumed and the equity method is applied. However, in this situation, Howard Company has virtually no influence because Larito Company holds a majority of the stock and does not pay any attention to Howard Company. Without the ability to apply significant influence, the equity method should not be adopted regardless of the amount of stock that is held.

The Reporting of Investments When Applying the Equity Method

Question: One company holds shares of another and has the ability to apply significant influence. Thus, the equity method of accounting is appropriate. What financial reporting is made of an investment when the equity method is used? What asset value is reported on the owner’s balance sheet and when is income recognized from the investment under this approach?

 

Answer: When applying the equity method, the investor does not wait until dividends are received to recognize profit from its investment. Because of the close relationship between the two companies, the investor reports income as it is earned by the investee. That is a key element of using the equity method. If, for example, a company reports net income of $100,000 in the current year, an investor holding a 40 percent ownership interest immediately records an increase in its own income of $40,000 ($100,000 × 40 percent). The appropriate percentage of the investee’s income is recognized by the investor. The investor also increases its investment account by $40,000 to reflect the growth in the size of the investee company.

Because income is recognized by the investor as earned by the investee, it cannot be reported again when a subsequent dividend is collected. That would double-count the impact. Income must be recognized either when earned by the investee or when later distributed to the investor in the form of a dividend, but not at both times. The equity method uses the earlier date rather than the latter.

Eventual payment of a dividend actually shrinks the size of the investee company because it has fewer assets. To reflect that change in size, the investor decreases the investment account when a dividend is received if the equity method is applied. No additional income is recorded because it was recorded by the investor when earned by the investee.

Because of the fair value option, companies are also allowed to report equity investments as if they were trading securities. However, few investors seem to have opted to make this election. If chosen, the investment is reported at fair value despite the degree of ownership with gains and losses in the change of fair value reported within net income.

Application of the Equity Method Illustrated

Question: In applying the equity method, income is recognized by the investor when earned by the investee. Subsequent dividend collections are not reported as revenue by the investor but rather as a reduction in the size of the investment account to avoid including the income twice.

To illustrate, assume that Big Company buys 40 percent of the outstanding stock of Little Company on January 1, Year One, for $900,000. No evidence is present to indicate that Big lacks the ability to exert significant influence over the financing and operating decisions of Little. Thus, application of the equity method is appropriate. During Year One, Little reports net income of $200,000 and distributes a total cash dividend to its stockholders of $30,000. What journal entries are appropriate for an investor when the equity method is applied to an investment?

 

Answer: The purchase of 40 percent of Little Company for cash is merely the exchange of one asset for another. Thus, the investment is recorded initially by Big at its historical cost, as shown in Figure 12.11 “Acquisition of Shares of Little to Be Reported Using the Equity Method”.

Figure 12.11 Acquisition of Shares of Little to Be Reported Using the Equity Method

Ownership here is in the 20 to 50 percent range and no evidence is presented to indicate that the ability to apply significant influence is missing. Thus, according to U.S. GAAP, the equity method should be applied. That means Big recognizes its portion of Little’s $200,000 net income as soon as it is earned by the investee. As a 40 percent owner, Big accrues income of $80,000 ($200,000 × 40%). Because earning this income caused Little Company to grow, Big increases its investment account to reflect the change in the size of the investee. Big’s journal entry is shown in Figure 12.12 “Income of Investee Recognized by Investor Using the Equity Method”.

Figure 12.12 Income of Investee Recognized by Investor Using the Equity Method

Big recognized its share of the income from this investee as it was earned. Consequently, any eventual dividend received from Little is a reduction in the investment rather than a new revenue. The investee company is smaller as a result of the cash payout. The balance in this investment account rises when the investee reports income but falls (by $12,000 or 40 percent of the dividend distribution of $30,000) when that income is later passed through to the stockholders.

Figure 12.13 Dividend Received from Investment Accounted for by the Equity Method

At the end of Year One, the investment account appearing on Big’s balance sheet reports a total of $968,000 ($900,000 + 80,000 − 12,000). This balance does not reflect fair value as was appropriate with investments in trading securities and available-for-sale securities. Unless impaired, fair value is ignored in reporting an equity method investment.

The reported amount also does not disclose historical cost. Rather, the asset figure determined under the equity method is an unusual mixture. It is the original cost of the shares plus the investor’s share of the investee’s subsequent income less any dividends received since the date of acquisition. Under the equity method, the investment balance is a conglomerate of amounts.

Test Yourself

Question:

Giant Company buys 30 percent of the outstanding stock of Tiny Company on January 1, Year One for $300,000. This ownership provides Giant with the ability to significantly influence the operating and financing decisions of Tiny. Subsequently, Tiny reports net income of $70,000 each year and pays an annual cash dividend of $20,000. Giant does not elect to report this investment as a trading security. Which of the following statements is true?

  1. Giant will report this investment at $342,000 on December 31, Year Two.
  2. Giant will report this investment at $363,000 on December 31, Year Three.
  3. Giant will report income from this investment of $27,000 in Year Two.
  4. Giant will report income from this investment of $21,000 in Year Three.

Answer:

The correct answer is choice d: Giant will report income from this investment of $21,000 in Year Three.

Explanation:

Because the ability to apply significant influence is held, Giant uses the equity method. Each year, income of $21,000 is recognized ($70,000 × 30 percent) with an increase in the investment. Dividends are reported by Giant as a $6,000 reduction in the investment and not as income. The investment balance grows at a rate of $15,000 per year ($21,000 increase less $6,000 decrease) so that it is reported as $315,000 at the end of Year One, $330,000 (Year Two), and $345,000 (Year Three).

Selling an Investment Reported by Means of the Equity Method

Question: Assume, at the end of Year One, after the above journal entries have been made, Big sells all of its shares in Little Company for $950,000 in cash. When the equity method is applied to an investment, what is the appropriate recording of an eventual sale?

 

Answer: Any investment reported using the equity method quickly moves away from historical cost as income is earned and dividends received. After just one year in this illustration, the asset balance reported by Big has risen from $900,000 to $968,000 (income of $80,000 was added and $12,000 in dividends were subtracted). If these shares are then sold for $950,000, a loss of $18,000 is recognized, as shown in Figure 12.14 “Sale of Investment Reported Using the Equity Method”.

Figure 12.14 Sale of Investment Reported Using the Equity Method

If the shares of Little had been sold for more than their $968,000 carrying value, a gain on the sale is recorded.

Summary. All investments in the stock of another company—where ownership is no more than 50 percent—must be accounted for in one of three ways depending on the degree of ownership and the intention of the investor: as trading securities, as available-for-sale securities, or according to the equity method. Figure 12.15 “Comparison of Three Methods to Account for Investments” provides an overview of the essential differences in these three accounting approaches. Note here that the available-for-sale securities and the investment using the equity method will have the same accounting as the trading securities if the fair value option is chosen.

Figure 12.15 Comparison of Three Methods to Account for Investments

Test Yourself

Question:

A company holds many investments in the stock of other companies. A dividend is received from one of these investments. Which of the following is true?

  1. If the equity method is applied, the investment balance is increased.
  2. If the investment is a trading security, the investment balance is reduced.
  3. If the investment is available-for-sale, net income is increased.
  4. If the equity method is applied, net income is increased.

Answer:

The correct answer is choice c: If the investment is available-for-sale, net income is increased.

Explanation:

For trading securities and available-for-sale securities, dividends are recorded as income and have no impact on the investment balance. For an equity method investment, dividends are recorded as a reduction in the investment account with no change reported in net income.

Test Yourself

Question:

A company holds many investments in the stock of other companies. One of these investments goes up in value by $10,000. Which of the following is true?

  1. Net income increases if the investment is available-for-sale.
  2. Net income increases if the investment is a trading security.
  3. Net income increases if the equity method is applied.
  4. Comprehensive income increases if the equity method is applied.

Answer:

The correct answer is choice b: Net income increases if the investment is a trading security.

Explanation:

Increases in value are not recorded when the equity method is in use. For trading securities, they increase net income. For available-for-sale securities, they do not increase net income but are recorded as other accumulated comprehensive income in the stockholders’ equity section of the balance sheet. They are then used in adjusting net income to arrive at comprehensive income.

Key Takeaway

An investor can gain enough equity shares of another company to have the ability to apply significant influence to its operating and financing decisions. For accounting purposes, use of the equity method then becomes appropriate. The point where significant influence is achieved can be difficult to gauge, so ownership of 20–50 percent of the stock is the normal standard applied in practice. However, if specific evidence is found indicating that significant influence is either present or does not exist, that information takes precedence regardless of the degree of ownership. According to the equity method, income is recognized by the investor as soon as earned by the investee. The investment account also increases as a result of this income recognition. Conversely, dividends are not reported as income but rather as reductions in the investment balance. Unless an impairment occurs, fair value is not taken into consideration in accounting for an equity method investment. When sold, the book value of the asset is removed, and any difference with the amount received is recognized as a gain or loss.

12.4 Reporting Consolidated Financial Statements

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. List various reasons for one company to seek to gain control over another.
  2. Recognize that consolidated financial statements must be prepared if one company has control over another which is normally assumed at the point when ownership is over 50 percent of the other company’s outstanding stock.
  3. Explain the reporting of a subsidiary’s revenues and expenses when consolidated financial statements are prepared at the date of acquisition.
  4. Explain the reporting of a subsidiary’s assets and liabilities when consolidated financial statements are prepared at the date of acquisition.

Accounting for Mergers and Acquisitions

Question: Companies frequently buy more than 50 percent of the stock of other companies in order to gain control. In a large number of these transactions, one company obtains all the outstanding shares of the other so that ownership is complete. If two companies are brought together to form a third, a merger has taken place. If one company simply buys another, the transaction is referred to as an acquisition. These corporate purchases can be monetarily huge and have a long-lasting impact on an industry or the economy as a whole. “Global dollar volume in announced mergers and acquisitions rose 23.1 percent in 2010, to $2.4 trillion, according to Thomson Reuters data. In the United States, merger volume rose 14.2 percent, to $822 billion.”Michael J. de la Merced and Jeffrey Cane, “Confident Deal Makers Pulled Out Checkbooks in 2010,” DealB%k (January 3, 2011), http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/.

  • Such investments are often made to expand operations into new markets or new industries. Google, for example, acquired YouTube for $1.65 billion to provide an entrance into online videos.
  • As discussed earlier in the coverage of intangible assets, one company might buy another to obtain valuable assets such as patents, real estate, trademarks, technology, and the like. The purchase by Walt Disney of Pixar and its digital animation expertise certainly falls into this category.
  • A takeover can also be made to eliminate competition or in hopes of gaining economies of scale. The $35 billion merger of Sprint with Nextel was projected to increase profits for the combined companies by lowering operating expenses while also reducing the number of competitors in the wireless communication industry.

To help demonstrate the appropriate method of accounting for such investments, assume that Giant Company acquires 100 percent of Tiny Company. Obviously, Giant has gained control of Tiny. How is the reporting by Giant affected? Because over 50 percent of the stock was purchased, none of the previously described accounting methods are applicable. How does a company report the acquisition of another company where control is established?

 

Answer: The stockholders of Giant now control both Giant and Tiny. As a result, a business combination has been formed from the two previously independent companies. For external reporting purposes, consolidated financial statementsStatements that are prepared when one company holds control over another company so that all assets, liabilities, revenues, and expenses must be combined in a method stipulated by U.S. GAAP; control is assumed to exist when more than 50 percent of the ownership shares are owned. are required. Giant does not report an investment in Tiny on its balance sheet as with the other accounting methods described previously. Instead, the individual account balances from each organization are put together in a prescribed fashion to represent the single economic entity that has been created. In simple terms, the assets, liabilities, revenues, and expenses of Tiny (the subsidiary) are consolidated with those of Giant (the parent) to reflect the united business.

Because such acquisitions are common, the financial statements reported by most well-known corporations actually include consolidated financial data from dozens, if not hundreds, of different subsidiaries where control has been gained over a number of years. As just one example, Cisco Systems made over 40 acquisitions of other companies between 2006 and 2011. Consolidated financial statements published today by Cisco Systems will include the revenues, expenses, assets, and liabilities of each of those subsidiaries along with those same accounts for the parent.

Consolidation of financial statements is one of the most complex topics in all of financial accounting. However, the basic process is quite straightforward.

Subsidiary revenues and expenses. The revenues and expenses reported by each subsidiary are included in consolidated figures but only for the period of time after control is obtained. Consequently, if Giant obtains Tiny by buying 100 percent of its stock on April 1, Year One, a consolidated income statement will contain no revenues and expenses recognized by Tiny prior to that date. Income statement balances accrued under previous owners have no financial impact on the new owner (Giant). Only the revenues earned and expenses incurred by this subsidiary after April 1 are included in consolidated totals.

Subsidiary assets and liabilities. Consolidation of subsidiary assets and liabilities is a more complicated process. On the date of the takeover, a total acquisition price is determined based on the fair value surrendered by the parent to gain control. A search is then made to identify all of the individual assets and liabilities held by the subsidiary at that time. As discussed previously, the parent recognizes subsidiary assets (1) that provide contractual or legal rights or (2) that can be separated from the subsidiary and then sold. Fair value is established and recorded for each of these assets as if the parent were acquiring them individually. A transaction has taken place that brings all of the subsidiary properties under the control of the parent.

Also, as explained previously, if the acquisition price is more than the total fair value of these identifiable assets and liabilities, the intangible asset goodwill is reported for the excess. As a going concern, a total value is usually attributed to a company that exceeds the individual values of its assets and liabilities. Having loyal customers and trained employees, for example, helps a company generate more profits than its assets could otherwise earn. When a company is being bought, such anticipated profitability usually leads to an increase in the negotiated price. This excess amount necessitates the recognition of goodwill on the consolidated balance sheet.

Test Yourself

Question:

Tall Company buys all the outstanding stock of Small Company on November 1, Year One for $500,000 and is now preparing consolidated financial statements at the end of Year One. Small earned revenues of $10,000 per month during Year One along with expenses of $8,000 per month. On November 1, Year One, Small had one asset—a piece of land with a cost of $300,000 and a fair value of $450,000—and no liabilities. The land continues to appreciate in value and is worth $470,000 at the end of Year One. Which of the following statements is true about the consolidated financial statements at the end of Year One?

  1. Consolidated net income will include $4,000 earned by Small.
  2. Goodwill at the end of Year One is reported as $30,000.
  3. The land owned by Small is reported at the end of Year One at $470,000.
  4. On consolidated financial statements, a $150,000 gain is reported on the land that was owned by Small.

Answer:

The correct answer is choice a: Consolidated net income will include $4,000 earned by Small.

Explanation:

In consolidation, only revenues and expenses recognized by Small after the purchase are included. Revenues of $20,000 ($10,000 × 2 months) for November and December are recorded this year as well as expenses of $16,000 ($8,000 × two months). The value of subsidiary assets and liabilities at the date of acquisition serves as the basis for reporting so the land will be shown in consolidation at $450,000. Because $500,000 was paid by the parent, goodwill is the excess $50,000.

The Consolidation of Financial Information

Question: To illustrate the consolidation process, assume that Tiny has earned revenues of $800,000 and incurred expenses of $500,000 during the year to date. In addition, the company reports a single asset, land costing $400,000 but with a $720,000 fair value. The only liability is a $300,000 note payable. Thus, the company’s reported net book value is $100,000 ($400,000 land less $300,000 note payable). Tiny also owns the rights to a well-known trademark that has no book value because it was developed many years ago at little or no cost. However, it is now estimated to be worth $210,000.

The assets and liabilities held by Tiny have a net fair value of $630,000 ($720,000 land plus $210,000 trademark less $300,000 note payable). Over the years, the company has been extremely popular and developed a large customer base. Therefore, after extensive negotiations, Giant agrees to pay $900,000 in cash to acquire all the outstanding stock of Tiny. If consolidated financial statements are created at the time of a corporate acquisition, what figures are reported by the business combination?

 

Answer: In consolidating Giant and its subsidiary Tiny at the date of this acquisition, neither the subsidiary revenues of $800,000 nor its expenses of $500,000 are included. Their financial impact occurred prior to the takeover by Giant. Those profits benefited the previous owners. Therefore, only revenues and expenses reported by Giant make up the consolidated income statement totals determined on the day the parent acquires this subsidiary.

At the same time, consolidated balance sheet totals will not show any “investment in Tiny Company” as in the other methods demonstrated earlier. Instead, Tiny’s land is added to Giant’s own totals at its $720,000 fair value, and the trademark is consolidated at its $210,000 fair value. These balances reflect the amounts paid by Giant to acquire ownership of the subsidiary. The note payable is included in the consolidated figures at $300,000, which was its fair value as well as its book value. Subsidiary assets and liabilities are consolidated as if purchased by the parent on an open market.

The acquisition price of $900,000 paid by Giant exceeds the net value of the subsidiary’s identifiable assets and liabilities ($630,000 or $720,000 + $210,000 − $300,000) by $270,000. In consolidation of a parent and subsidiary, any excess acquisition payment is assumed to represent goodwill and is reported as an intangible asset.

Figure 12.16 Consolidated Totals—Date of Acquisition

Test Yourself

Question:

Large Company produces a balance sheet that shows patents with a book value of $200,000. The next day, Large Company buys all of Short Company for $3 million. Consolidated financial statements are then produced that show patents with a book value of $300,000. What does the reader of these financial statements know about the patents held by Large and its consolidated subsidiary?

  1. Acquiring Short made the patents held by Large more valuable.
  2. At the date of acquisition, Short held patents with a fair value of $100,000.
  3. At the date of acquisition, Short held patents with a historical cost of $100,000.
  4. At the date of acquisition, Short held patents with a net book value (cost minus accumulated amortization) of $100,000.

Answer:

The correct answer is choice b: At the date of acquisition, Short held patents with a fair value of $100,000.

Explanation:

On the date that a business combination is formed, the fair value of all identifiable assets and liabilities of the subsidiary are added to those same accounts of the parent. Because the patent account balance went up by $100,000 as a result of the purchase, that figure was the apparent fair value of any patents held by Short Company at that time.

Analyzing a Company’s Use of Its Assets

Question: This chapter completes coverage of the assets reported by an organization on its balance sheet. In earlier chapters, vital signs were computed and explained in connection with receivables, inventory, and property and equipment. Figures and ratios were presented that are often used in evaluating a business—especially its financial health and future prospects. Do any similar vital signs exist for assets as a whole that decision makers will typically determine as part of an overall examination of an organization such as PepsiCo or The Coca-Cola Company?

 

Answer: A company controls a specific amount of assets. Investors and other decision makers are interested in how effectively management is able to make use of these resources. Individuals who study specific companies search for signs that an appropriate level of income was generated from the assets on hand.

Total asset turnoverTotal asset turnoverA ratio used to measure the efficient use of assets; it is computed by dividing sales revenue by average total assets for the period. is one such figure. It indicates management’s efficiency at generating sales revenue. Sales must occur before profits can be earned from normal operations. If assets are not well used to create sales, profits are unlikely to arise.

total asset turnover = sales revenue/average total assets

To illustrate, here is information reported for 2010 by PepsiCo Inc. and The Coca-Cola Company. Based on these figures, the total asset turnover can be computed for each company for comparison purposes as shown in Figure 12.17 “2010 Comparison of “.

Figure 12.17 2010 Comparison of PepsiCo Inc. and The Coca-Cola Company

Return on assets. Probably one of the most commonly used vital signs employed in studying the financial health of a company is its return on assetsA ratio used to measure the profitable use of assets by a company’s management; it is computed by dividing net income by the average total assets for the period., often known as ROA. It is computed by taking net income and then dividing that figure by the average total assets for the period. It is viewed by many as an appropriate means of measuring management’s efficiency in using company resources.

return on assets (ROA) = net income/average total assets

Variations of this formula do exist. For example, some analysts modify the income figure by removing interest expense to eliminate the impact of different financing strategies so that the computation focuses on operations.

For 2010, PepsiCo reported net income of $6.3 billion so that its ROA for the year was 11.7 percent ($6.3 billion net income/$54.0 billion as the average total assets). For the same period, The Coca-Cola Company reported net income of $11.8 billion for an ROA of 19.4 percent ($11.8 billion net income/$60.8 billion in average total assets).

Key Takeaway

Companies attempt to obtain control of other companies for many reasons including obtaining access to valuable assets, gaining entry into new industries, and eliminating competition. According to U.S. GAAP, control is established over another company by acquiring 50 percent or more of its ownership shares. At that point, consolidated financial statements must be prepared bringing together the financial accounts from both companies. For the subsidiary, only revenues and expenses since the takeover are included. In consolidating the assets and liabilities of the subsidiary, the fair value at the date of acquisition is assumed to represent the cost incurred by the parent. The intangible asset goodwill is reported for any unexplained excess payment made by the parent in acquiring control over the subsidiary. To evaluate the efficiency of management’s use of company assets, many analysts compute total asset turnover and return on assets (ROA).

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: For the year ended December 31, 2010, The Dow Chemical Company reported its net income as approximately $2.321 billion. The company also disclosed comprehensive income for the same period of only $1.803 billion. That’s a 22 percent reduction. Are you disturbed that a company can report two separate income figures that are so significantly different? Or, do you find disclosing income in two distinct ways to be helpful when you analyze a business?

Kevin Burns: Actually I think the idea of disclosing income in two different ways makes sense. Having said that, if I were a shareholder of Dow Chemical, I would want to know why these numbers are so far apart? What exactly is included in (or excluded from) each of these income figures? Is the company’s core business sound? This question is probably best answered by net income. The reduction in arriving at comprehensive income is likely to have come from losses in the value of available-for-sale investments and from holding foreign currency balances. That can provide interesting information. Perhaps the management is distracted by trying to manage a large stock investment portfolio. How much of the difference comes from currency rate changes, and is there a way to hedge this volatility to reduce the impact? If there is a way to hedge that risk, why did company officials choose not to do so?

In sum, the reason I like including both income numbers is that anything that increases disclosure is a positive, especially when investing money. The more transparency the better is my feeling. Then, investors can make up their own minds as to management’s competence and the future success of the overall business operations.

12.5 End-of-Chapter Exercises

Questions

  1. On January 1, Year One, the Lawrence Company acquires 10,000 shares of the Memphis Company for $39 per share. What are possible reasons why Lawrence chose to use its cash to make this acquisition?
  2. Wilson Company buys 200 shares of Pepitone Corporation for $17 per share, an asset that is classified as an investment in trading securities. Why is an investment classified in this manner?
  3. An investor owns equity shares of a number of companies. Some of these investments are reported as trading securities while others are shown as available-for-sale securities. The investor receives a cash dividend of $1,000. How is that receipt reported by the investor?
  4. The Amos Corporation bought 1,000 shares of Jones Company during Year One for $18 per share. The investment is labeled as a trading security. Amos plans to sell these shares on the stock market for $27 each and is trying to decide whether to make the sell on December 30, Year One, or January 2, Year Two. How will reported net income differ in Year One and in Year Two based on the timing of this sale?
  5. Unless value is impaired, equipment and inventory are reported based on historical cost. Why is the financial accounting of an investment in trading securities handled differently from these other assets?
  6. StampCo Corporation bought 1,000 shares of Bates Corporation on December 1, Year One. Company officials are trying to decide whether to report this asset as an investment in trading securities or as an investment in available-for-sale securities. How is this decision made?
  7. Company A bought 1,000 shares of Company Y for $13 per share and 2,000 shares of Company Z for $18 per share. At the end of the year, the stock of Company Y is worth $15 per share and the stock of Company Z is worth $14 per share. What is reported at year-end if these investments are both classified as investments in trading securities? What is reported at year-end if these investments are both classified as investments in available-for-sale securities?
  8. An investment is bought during Year One for a total of $9,000. At the end of Year One, these shares are worth $10,000. However, they are sold on February 11, Year Two, for only $6,000. What is the income effect for these two years if this stock is viewed by company officials as a trading security? What is the income effect for these two years if this stock is viewed by company officials as available-for-sale?
  9. A company acquires an investment in available-for-sale securities during Year one for $23,000. At the end of the year, this investment was worth $19,000. Reported net income was $200,000. What should the company report as its comprehensive income?
  10. The Lincoln Corporation bought 1,000 shares of Illinois Company during Year One for $21 per share. The investment is labeled as available-for-sale. Lincoln plans to sell these shares on the stock market for $26 each and is trying to decide whether to make the sell on December 30, Year One, or January 2, Year Two. How will reported net income differ in Year One and in Year Two based on the timing of this sale?
  11. Big Company acquired enough shares of Little Company so that it has gained the ability to exert significant influence over its operating and financing decisions. How should Big report this investment?
  12. Mama Corporation acquired a rather large block of the capital shares of Child Corporation. Currently, company officials for Mama are trying to decide whether application of the equity method is appropriate. In theory, how is that decision made? In practice, how is that decision made?
  13. Archibald Corporation owns 30 percent of Saratoga Corporation and will apply the equity method to this investment. During the current year, Saratoga reported net income of $150,000 and paid a total cash dividend of $60,000. What reporting is required of Archibald in connection with this investment?
  14. Why are dividends that are received from an investment that is being accounted for by means of the equity method not reported as revenue?
  15. The Walters Company acquired 40 percent of the Ameston Company on January 1, Year One, for $388,000. Ameston reported net income of $100,000 for Year One and paid a total cash dividend of $40,000. At the end of Year One, this investment was worth $460,000. What is reported on the owner’s balance sheet for this investment, and what does that figure represent?
  16. Giant Corporation buys 54 percent of the outstanding stock of Small Corporation. Under normal conditions, how will this investment be reported?
  17. Lauderdale Corporation has two assets. The land cost $100,000 and is worth $220,000. A building has a net book value of $650,000 and a fair value of $730,000. Yarrow Corporation buys 100 percent of the outstanding stock of Lauderdale for cash of $1 million. What journal entry does Yarrow make to consolidate Lauderdale’s assets within its own financial records?
  18. Donnelly Corporation generated revenues of $900,000 during Year One while Nelson Company generated revenues of $600,000 during the same period. On the last day of the year, Donnelly buys all of the ownership shares of Nelson. In consolidated financial statements for December 31, Year One, and the year then ended, what is the reported amount of revenues?
  19. Financial analysts determine the total asset turnover for the Paquet Corporation as 2.3. How did these decision makers arrive at this figure?
  20. Financial analysts study the financial statements reported by Williamston Corporation and calculate a return on assets of 11.3 percent. How did they arrive at that figure?

True or False

  1. ____ To keep the information relatively simple for financial statement users, all investments in the ownership shares of other companies are accounted for in the same way according to U.S. GAAP.
  2. ____ If the owner of trading securities receives a cash dividend, it should be recorded as revenue at that time and shown on the income statement.
  3. ____ All investments in other companies should be reported at the historical cost of the investment.
  4. ____ A company buys trading securities in Year One for $11,000. They increase in value by $2,000 in Year One and are then sold in Year Two for $14,000. A gain of $3,000 is recognized on the company’s income statement in Year Two.
  5. ____ The Argentina Company buys shares of another company and is currently attempting to determine whether this ownership qualifies as an investment in trading securities or available-for-sale securities. The total amount of assets reported by Argentina will vary depending on which approach is selected.
  6. ____ Changes in the value of available-for-sale securities do not affect the reported net income of the investor until the securities are sold.
  7. ____ The Nile Company buys 100 shares of a company for $7,000 in cash in Year One. The shares increase in value by $1,000 in Year One and then by $2,000 in Year Two and are then sold. In addition, a dividend is received from this investment of $300. In Year Two, the Nile Company will increase its net income by $3,300 if this investment is judged to be a trading security.
  8. ____ At the beginning of Year One, the Barksdale Corporation buys shares of another company for $7,000. The stock goes up in value during Year One by $5,000. Dividends of $1,000 are also collected. Company officials view this as an investment in available-for-sale securities. If net income is reported as $40,000, then comprehensive income will be $45,000.
  9. ____ Accumulated other comprehensive income is included by a company on its income statement within the computation of net income.
  10. ____ If one company owns 25 percent of another company, it must use the equity method to account for this investment.
  11. ____ Equity method investments are reported at current fair value on the owner’s balance sheet.
  12. ____ On January 1, Year One, Ajax Company spends $200,000 on an investment. In this purchase, the company gains 30 percent ownership of another company and the ability to apply significant influence. During Year One, the other company reports net income of $50,000 and distributes a cash dividend of $10,000. Ajax should report dividend revenue of $3,000.
  13. ____ On January 1, Year One, Dylan Company spends $300,000 on an investment. The company buys 30 percent of another company and gains the ability to apply significant influence. During Year One, the other company reports net income of $70,000 and distributes a cash dividend of $20,000. At the end of the year, these shares have a fair value of $400,000. Ajax should report the investment on its balance sheet at $315,000.
  14. ____ Big Company has held 30 percent of Little Company’s ownership for several years and uses the equity method for financial reporting. Little reports net income in the current year of $40,000 while paying no dividends. Big reports its share of Little’s net income in the current year.
  15. ____ Consolidated financial statements are only created when one company acquires 100 percent ownership over another company.
  16. ____ Bismarck Company buys control over another company late in Year One. One of the likely reasons for this acquisition is so that the revenues earned throughout the year can be added to those of Bismarck on consolidated statements to make that company’s financial situation look better.
  17. ____ Reinstein Company has net assets with a net book value of $600,000 but a fair value of $740,000. If a company buys control over Reinstein for $740,000, no goodwill is recognized.
  18. ____ The NYork Company has only one asset and no liabilities. It owns a building that it rents out. The building has a net book value of $800,000 but is worth $960,000. Another company paid exactly $1 million to gain all of the outstanding stock of NYork. The building will be added to consolidated financial statements on that date at $960,000.
  19. ____ The higher a company’s ROA, the more efficiently the company is using its assets.

Multiple Choice

  1. On November 5, Year One, Maxwell Corporation purchased seventy shares of Tyrone Company for $30 per share, planning to hold the investment for a short time and then sell these shares. At the end of Year One, Tyrone is selling for $32 per share on a stock exchange. What unrealized gain will Maxwell report for Year One, and where should that balance be reported?

    1. $140 unrealized gain, stockholders’ equity section of balance sheet
    2. $140 unrealized gain, income statement
    3. $2,240 unrealized gain, income statement
    4. $2,240 unrealized gain, stockholders’ equity section of balance sheet
  2. Which of the following is not a reason investments in trading securities are shown at fair value on the balance sheet?

    1. The fair values of publicly-traded securities are readily available.
    2. Fair value is considered relevant information to financial statement users.
    3. The fair value is an objective amount determined by the stock market.
    4. Fair value is easier to determine than historical cost.
  3. Hope Corporation buys shares of Lonesome Corporation for $14,000 during Year One. By year-end, the stock has a total market value of $18,000. Which of the following is not true?

    1. If viewed as a trading security, the asset is reported on the balance sheet at $18,000.
    2. If viewed as a trading security, Hope’s net income will increase in Year One by $4,000.
    3. If viewed as an available-for-sale security, the asset is reported on the balance sheet at $18,000.
    4. If viewed as an available-for-sale security, Hope’s net income will increase in Year One by $4,000.
  4. An investor spends $23,000 for shares of another company late in Year One. The shares are worth $24,000 at the end of that year. Early in Year Two, a $1,200 dividend is received from this investment. Shortly thereafter, the shares are sold for $26,000. If this asset is an investment in trading securities, what is the impact on net income in Year Two?

    1. Increase by $1,200.
    2. Increase by $2,000.
    3. Increase by $3,200.
    4. Increase by $4,200.
  5. The Andre Corporation spends $35,000 for shares of another company late in Year One. The shares are worth $34,000 at the end of that year. Early in Year Two, a $900 dividend is received from this investment. Shortly thereafter, the shares are sold for $38,000. If this asset is viewed as an investment in trading securities, what is the impact on net income in Year Two?

    1. Increase by $3,000
    2. Increase by $3,900
    3. Increase by $4,000
    4. Increase by $4,900
  6. Early in Year One, Jackson Corporation purchased 150 shares of Riley Corporation for $46 per share. The investment is classified as available-for-sale. At the end of Year One, Riley’s stock is selling on a stock exchange for $43 per share. Jackson’s reported net income for the year was $235,000. What should Jackson report as its comprehensive income for Year One?

    1. $228,100
    2. $228,550
    3. $234,550
    4. $235,000
  7. In Year One, Jeremiah Corporation purchased shares of Lauren Corporation for $9,000. The investment is classified as a trading security. At the end of Year One, Lauren’s stock has a value on a stock exchange equal to $13,000. Jeremiah’s reported net income for the year was $180,000. What should Jeremiah report as its comprehensive income for Year One?

    1. $180,000
    2. $184,000
    3. $189,000
    4. $193,000
  8. The Monroe Corporation owns the capital stock of several corporations and receives a cash dividend of $7,000 this year. Which of the following statements is true?

    1. For both trading securities and available-for-sale securities, the dividend is a reduction in the investment account.
    2. For trading securities, the dividend is included in net income; for available-for-sale securities, the dividend is a reduction in the investment account.
    3. For trading securities, the dividend is a reduction in the investment account; for available-for-sale securities, the dividend is included in net income.
    4. For both trading securities and available-for-sale securities, the dividend is included in net income.
  9. Wisconsin Corporation makes an investment in Badger Corporation for $38,000 at the beginning of Year One. At the end of the year, the shares are selling at an amount equal to $34,000. The drop in value is viewed as temporary. During the period, Badger earned $30,000 in income and Wisconsin received a dividend of $1,800. Which of the following is not true?

    1. If this investment is viewed as a trading security, it should be reported on a year-end balance sheet at $34,000.
    2. If this this investment is viewed as available-for-sale, dividend revenue is recognized for $1,800.
    3. If this investment is viewed as a trading security, dividend revenue is recognized for $1,800.
    4. If this investment is accounted for by means of the equity method, it should be reported on a year-end balance sheet at $34,000.
  10. Anton Company owns shares of Charlotte Corporation. Which of the following is true about the reporting for this investment?

    1. If Anton owns 15 percent of Charlotte and has significant influence, the investment must be reported by the equity method.
    2. If Anton owns 25 percent of Charlotte and does not have significant influence, the investment must be reported by the equity method.
    3. If Anton owns 4 percent of Charlotte and does not have significant influence, the investment must be reported as a trading security.
    4. If Anton owns 56 percent of Charlotte and has control, the investment must be reported by the equity method.
  11. Rocko Corporation acquires 40 percent of Hailey Corporation on January 1, Year One, for $400,000. By this purchase, Rocko has gained the ability to exert significant influence over Hailey. Hailey reports net income of $80,000 in Year One and $100,000 in Year Two. Hailey pays a total dividend of $30,000 each year. These shares have a value of $460,000 at the end of Year One and $500,000 at the end of Year Two. On a December 31, Year Two, balance sheet, what does Rocko report for this investment?

    1. $448,000
    2. $472,000
    3. $500,000
    4. $520,000
  12. Lancaster Inc. purchases all the outstanding stock of Lucy Company for $4,500,000. The net assets of Lucy have a total fair value of $2,900,000. These assets include a patent with a net book value of $4,700 and a fair value of $159,000. At what amount should the patent and any goodwill from this purchase be shown on consolidated financial statements produced on the date of purchase?

    1. Patent—$4,700; Goodwill—$0
    2. Patent—$159,000; Goodwill—$0
    3. Patent—$159,000; Goodwill—$1,600,000
    4. Patent—$4,700; Goodwill—$1,600,000
  13. On December 31, Year One, Brenda Corporation purchased 100 percent of Kyle Inc. for $3,400,000. The net assets of Kyle had a net book value of $3 million. Kyle had a trademark with a fair value ($45,000) that exceeded its book value ($15,000) by $30,000. For all other assets and liabilities reported by Kyle, net book value was the same as fair value. At what amounts should the trademark and goodwill be shown on Brenda’s consolidated balance sheet on December 31, Year One?

    1. Trademark—$15,000; Goodwill—$370,000
    2. Trademark—$15,000; Goodwill—$400,000
    3. Trademark—$45,000; Goodwill—$370,000
    4. Trademark—$45,000; Goodwill—$400,000
  14. On December 31, Year One, the Bolger Corporation purchases all of the capital stock of Osbourne Corporation for $200,000 more than the fair value of the subsidiary’s identifiable assets and liability. During Year One, Bolger reported revenues of $900,000 and expenses of $600,000. In the same period, Osbourne reported revenues of $700,000 and expenses of $500,000. On a consolidated income statement for Year One, what is reported for revenues and expenses?

    1. Revenues—$900,000; Expenses—$600,000
    2. Revenues—$1.6 million; Expenses—$600,000
    3. Revenues—$900,000; Expenses—$1.1 million
    4. Revenues—$1.6 million, Expenses—$1.1 million
  15. Hydro Company and Aqua Corporation are in the same industry. During Year One, Hydro had average total assets of $35,000 and sales of $47,800. Aqua had average total assets of $49,000 and sales of $56,900. Which of the following is true?

    1. Aqua Corporation has a total asset turnover of 0.86 times.
    2. Hydro Company is not using its assets as efficiently as Aqua Corporation.
    3. Aqua Corporation has a higher ROA than Hydro Company.
    4. Hydro Corporation has a total asset turnover of 1.37 times.
  16. Tried Company began the year with $450,000 in total assets and ended the year with $530,000 in total assets. Sales for the year were $560,000 while net income for the year was $46,000. What was Tried Company’s return on assets (ROA) for the year?

    1. 8.2%
    2. 9.4%
    3. 10.2%
    4. 14.0%

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while waiting for a bus to go across campus, your roommate poses this question: “As you can imagine, my parent’s business is very seasonal. They do great during the summer but not nearly as well in the winter. So, the business has to save up enough cash by the end of summer to support operations over the colder months. This year the business bought shares of several well-known companies in September that will be sold in February when cash reserves begin to run low. Unfortunately, the stock market went down, and now my parents are telling me that they have to report a loss at the end of December. I don’t understand. If they are not going to sell this stock until February, why do they have to report a loss in December? The stock market price may well go way up by the time they sell those shares in February. They have plenty of time to recoup the lost value.” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has expanded and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “We have some friends who own an office supply service in the next state. They had been having some trouble, so at the beginning of the current year, our company bought 35 percent of their company for a considerable amount of money. We have plans to help them get their operations turned around. We believe, in the long run, that this investment will be very profitable as they begin to make the changes we suggest. This year, that other company only made a profit of $40,000 and paid a total cash dividend of $10,000. However, in the future, we believe that they will do much better. We’ve never owned a portion of a business like this before. How do we go about accounting for our ownership interest in this other company?” How would you respond?

Problems

  1. The Kansas Company buys 1,000 shares of Topeka Inc. on August 1, Year One, for $19 per share. Topeka paid a $1 per share cash dividend on December 12, Year One. The shares are worth $23 per share on December 31, Year One. Kansas sells this entire investment on April 7, Year Two, for $25 per share.

    1. If this asset is viewed as an investment in trading securities, what is reported in the Year One financial statements for Kansas?
    2. If this asset is viewed as an investment in trading securities, what is reported in the Year Two financial statements for Kansas?
    3. If this asset is viewed as an investment in available-for-sale securities, what is reported in the Year One financial statements for Kansas?
    4. If this asset is viewed as an investment in available-for-sale securities, what is reported in the Year Two financial statements for Kansas?
  2. Record Investor Corporation’s journal entry for each of the following events.

    1. Investor Corporation purchases 600 shares of stock in Company A for $60 per share on December 6, Year One. This investment is considered a trading security.
    2. At the end of Year One, Company A shares are selling for $63 each.
    3. On January 31, Year Two, Company A pays a cash dividend of $2 per share.
    4. At the end of Year Two, Company A shares are selling for $59 each.
    5. On January 22, Year Three, Investor sells all of the shares of Company A for $62 each.
  3. On September 9, Year One, Johnson Inc. purchased 500 shares of Thomas Company stock when this stock was selling for $20 per share. Johnson plans to hold these shares for a short time and hopefully sell the investment for a gain. Shortly thereafter, Thomas paid a cash dividend of $0.32 per share.

    On December 31, Year One, Johnson prepares its financial statements. At that time, this stock is selling for $18 per share.

    1. Determine all balances that Johnson will report on its Year One income statement in connection with this investment.
    2. Determine all balances that Johnson will report on its December 31, Year One, balance sheet in connection with this investment.
    3. If Johnson reports net income of $79,000 for Year One, what should be disclosed as comprehensive income?
  4. In Year One, Waterloo Corporation makes an investment in the equity securities of another company for $53,000. The company then collects a cash dividend of $2,000. At the end of Year One, this investment is valued at $58,000. In March of Year Two, the entire investment is sold for cash of $54,000.

    Waterloo reported this investment as being in available-for-sale securities. How would Waterloo’s reported net income have been different in each of these two years if the investment had been reported as a trading security?

  5. Record Christopher Corporation’s journal entry for each of the following events. After each entry, indicate the balances that will be reported on Christopher Corporation’s balance sheet at that date.

    1. Christopher Corporation purchases 1,000 shares of stock in Alpha Company for $30 per share on July 7, Year Two. This investment is considered an available-for-sale security.
    2. At the end of Year Two, Alpha Company’s stock is selling for $25 per share.
    3. At the end of Year Three, Alpha Company’s stock is selling for $28 per share.
    4. On February 16, Year Four, Alpha Company pays a $0.60 per share cash dividend to its stockholders.
    5. On March 27, Year Four, Christopher sells all of these shares for $36 per share in cash.
  6. On April 16, Youngstown Inc. purchased 900 shares of Cool Company stock when Cool’s stock was selling for $15 per share. Youngstown plans to hold this stock indefinitely until the company has a need for cash.

    1. On December 31, Cool’s stock is selling for $20 per share. What appears on the financial statements for Youngstown?
    2. If Youngstown reports net income of $190,000, what should the company report as its comprehensive income?
    3. Assume that Youngstown sells this investment three months later when Cool’s shares are selling for $24 per share. Make the journal entry to record the sale.
  7. Ordello Company buys 20 percent of the capital stock of Pottsboro Corporation on January 1, Year One, for $370,000. Ordello plans to hold these shares for an indefinite period of time. Pottsboro reports net income of $80,000 in Year One and $100,000 in Year Two. The company pays a total cash dividend of $30,000 in each year. Ordello’s investment is worth $420,000 at the end of Year One and $470,000 at the end of Year Two. Ordello sells this investment on the first day of Year Three for $470,000 in cash.

    1. Assume that the ownership of these shares does not give Ordello the ability to apply significant influence over Pottsboro. Make all journal entries for Ordello for Years One, Two, and Three.
    2. Assume that the ownership of these shares does give Ordello the ability to apply significant influence over Pottsboro. Make all journal entries for Ordello for Years One, Two, and Three.
  8. Oregon Company, a paper products manufacturer, wishes to enter the Canadian market. The company purchased 30 percent of the outstanding stock of Canadian Paper Inc. on January 1, Year One, for $6,000,000. The CEO of Oregon will sit on the board of directors of Canadian, and other evidence of significant influence does exist.

    1. Canadian reported net income of $760,000 for the year. Record the journal entry (if any) to be prepared by Oregon.
    2. Canadian paid a cash dividend of $80,000. Record the journal entry for Oregon.
    3. What amount would Oregon report on its balance sheet as its investment in Canadian as of the end of Year One?
  9. At the beginning of Year One, Current Properties paid $1,000,000 for 25 percent of the shares of Nealy Enterprises. Current immediately begins to exert significant influence over the operating decisions of Nealy.

    1. Nealy reported earnings of $400,000 during Year One. Record the appropriate journal entry for Current.
    2. Nealy paid a total cash dividend of $50,000 during October of Year One. Record the appropriate journal entry for Current when the company receives this dividend.
    3. At the end of Year One, what amount does Current report on its balance sheet as its investment in Nealy? What does Current report on its income statement as its investment income from Nealy?
    4. Nealy reported earnings of $440,000 during Year Two. Nealy paid dividends of $60,000 during Year Two. What is the balance of the Investment in Nealy at the end of Year Two?
    5. At the end of Year Two, Current sells its entire investment in Nealy for $1,200,000 in cash. Record the appropriate journal entry for Current.
  10. Teckla Corporation purchases all the outstanding stock of Feather Company on January 1, 20X3 for $5,000,000. Teckla’s balance sheet on that date before the purchase is shown in the following:

    Figure 12.18 Assets and Liabilities of Teckla

    On January 1, 20X3, Feather has assets and liabilities as shown in the following:

    Figure 12.19 Assets and Liabilities of Feather

    1. Determine the amount of goodwill (if any) that Teckla will show on its consolidated balance sheet at January 1, 20X3.
    2. Prepare a consolidated balance sheet for Teckla after it purchases Feather on January 1, 20X3.
  11. In several past chapters, we have met Heather Miller, who started her own business, Sew Cool. The following are the financial statements for December. To calculate average total assets, assume that total assets on June 1, 20X8, when Sew Cool first started in business, were zero.

    Figure 12.20 Sew Cool Financial Statements

    Figure 12.21

    Figure 12.22

    Based on the financial statements determine the following:

    1. Total asset turnover
    2. Return on assets

Comprehensive Problem

This problem will carry through several chapters, building in difficulty. It allows students to continually practice skills and knowledge learned in previous chapters.

In Chapter 11 “In a Set of Financial Statements, What Information Is Conveyed about Intangible Assets?”, financial statements for November were prepared for Webworks. They are included here as a starting point for the required recording for December.

Figure 12.23 Webworks Financial Statements

Figure 12.24

Figure 12.25

The following events occur during December:

  1. Webworks starts and completes nine more Web sites and bills clients for $5,000.
  2. Webworks purchases supplies worth $130 on account.
  3. At the beginning of December, Webworks had nine keyboards costing $111 each and ten flash drives costing $13 each. Webworks uses periodic FIFO to cost its inventory.
  4. Webworks purchases seventy keyboards for $113 each and one hundred flash drives for $15 each, all on account.
  5. Webworks decides to invest a small amount of its excess cash in the stock market in the hopes of making a quick gain. Webworks purchases sixty shares of stock in XYZ Corporation for $5 per share in cash.
  6. Webworks pays Nancy Po $750 for her work during the first three weeks of December.
  7. Webworks sells sixty-five keyboards for $9,750 and ninety flash drives for $1,800 cash.
  8. The Web site for the realtor started in November is completed.
  9. Webworks collects $4,500 in accounts receivable.
  10. Webworks pays off its salaries payable from November.
  11. Webworks pays off $10,500 of its accounts payable.
  12. XYZ Corporation pays Webworks a dividend of $40.
  13. Webworks pays Leon Jackson (the owner of the business) a salary of $2,000.
  14. Webworks pays taxes of $1,272 in cash.

    Required:

    1. Prepare journal entries for the previous events.
    2. Post the journal entries to T-accounts.
    3. Prepare an unadjusted trial balance for Webworks for December.
    4. Prepare adjusting entries for the following and post them to your T-accounts.
  15. Webworks owes Nancy Po $200 for her work during the last week of December.
  16. Leon’s parents let him know that Webworks owes $300 toward the electricity bill. Webworks will pay them in January.
  17. Webworks determines that it has $60 worth of supplies remaining at the end of December.
  18. Prepaid rent should be adjusted for December’s portion.
  19. Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
  20. Webworks continues to depreciate its equipment over four years and its furniture over five years, using the straight-line method.
  21. The license agreement should continue to be amortized over its one-year life.
  22. On December 31, XYZ stock is selling for $6 per share.
  23. Record cost of goods sold.
  24. Near the end of December, a new flash drive appears on the market that makes the ones Webworks has been selling virtually obsolete. Leon believes that it might be able to sell the rest of its inventory (twenty flash drives) for $5 each.

    1. Prepare an adjusted trial balance.
    2. Prepare financial statements for December.

Research Assignment

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for that firm is currently looking at the possibility of investing in Google. The partner is aware that Google holds an enormous amount of marketable securities. The partner is curious as to the actual size of that balance. The partner is also interested in knowing whether these marketable securities are reported as trading securities or as available-for-sale securities. The partner asks you to look at the 2010 financial statements for Google by following this path:

  • Go to http://www.google.com.
  • At the very bottom of this screen, click on “About Google.”
  • Near the top of the next screen, click on “Investor Relations.”
  • On the next screen, scroll to the bottom and click on “View 2011 Proxy Materials.”
  • On the next screen, in the center, click on “December 31, 2010 Annual Report” to download.
  • Go to page 49 and find the balance sheet for December 31, 2010.
  • Go to page 56 and read the second paragraph under “Cash, Cash Equivalents, and Marketable Securities” shown within Note One.
  1. Using the balance sheet information located on Google’s website, what is the dollar amount reported by Google as of December 31, 2010, for its “marketable securities?” What percentage does this asset comprise of the company’s total assets?
  2. Using the information found in the section of Note One describing “Cash, Cash Equivalents, and Marketable Securities,” determine whether these marketable securities are reported as trading securities or available-for-sale securities.

Chapter 11: In a Set of Financial Statements, What Information Is Conveyed about Intangible Assets?

Video Clip

(click to see video)

In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 11 “In a Set of Financial Statements, What Information Is Conveyed about Intangible Assets?”.

11.1 Identifying and Accounting for Intangible Assets

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. List the characteristics of intangible assets and provide several common examples.
  2. Understand that intangible assets are becoming more important to businesses and, hence, are gaining increased attention in financial accounting.
  3. Record the acquisition of an intangible asset.
  4. Describe the amortization process for intangible assets.
  5. Explain the accounting used to report an intangible asset that has increased in value since acquisition.

The Rise in the Importance of Intangible Assets

Question: Not so many years ago, the balance sheets of most large companies disclosed significant amounts of property and equipment but considerably smaller figures for intangible assetsAn asset lacking physical substance that is expected to help generate revenues for more than one year; common examples are patents, copyrights, and trademarks.. Businesses were often referred to as “bricks and mortar” operations because much of their money was invested in buildings and the long-lived tangible assets that were housed in those buildings.

Today, the basic nature of many corporate operations has changed dramatically. As of June 30, 2011, Microsoft Corporation reported a total of $13.3 billion for its “goodwill” and “intangible assets, net” versus only $8.2 billion in “property and equipment, net of accumulated depreciation.” For Yahoo! Inc., the difference is similarly striking. On December 31, 2010, Yahoo! disclosed $3.9 billion of “goodwill” and “intangible assets, net” but a mere $1.7 billion in “property and equipment, net.”

The rise in the number, value, and importance of intangible assets might well be the biggest change experienced in the reporting of businesses over the last ten to twenty years. The sudden growth of Internet and technology companies like Microsoft and Yahoo! has focused attention on the significance of ideas and innovation (rather than bricks and mortar) for achieving profits.

Financial accounting rules must evolve as the nature of business moves forward over time. Not surprisingly, considerable debate has taken place recently concerning the methods by which intangible assets are reported in a set of financial statements. A relatively minor topic in the past has gained a genuine level of importance in today’s accounting conversations. Should an idea or an invention be reported in the same manner as a building or a machine? For financial accounting, that is a very important question. As a starting point for this discussion, the basic nature of an intangible asset needs to be understood. What is an intangible asset and what are common examples?

 

Answer: As the title implies, an intangible asset is one that lacks physical substance. It cannot be touched but is expected to provide future benefits for longer than one year. More specifically, it will assist the reporting company in generating revenues in the future. Except for a few slight variations, intangible assets are reported in the same manner as a building or equipment. For example, historical cost serves as the basis for reporting. If the intangible has a finite life, the depreciation process (although the term amortizationA mechanically derived pattern allocating the cost of an intangible asset to expense over the shorter of the legal life or estimated useful life; it is the equivalent of depreciation but relates to intangible assets. is normally applied in reporting intangibles) reclassifies this cost from asset to expense over that estimated period.

U.S GAAP provides structure for the reporting process by placing all intangibles into six major categories:

  1. Artistic-related (such as copyrightsAn intangible asset that provides the owner with the right to use literary, dramatic, musical, artistic, and certain other intellectual works.)
  2. Technology-related (patents)
  3. Marketing-related (trademarks)
  4. Customer-related (a database of customer information)
  5. Contract-related (franchises)
  6. Goodwill

In all of these categories (except for goodwill, which will be explained later in this chapter), the intangible asset is actually an established right of usage. As an example, according to the Web site for the United States Copyright Office, a copyright provides its owner with the right to use “literary, dramatic, musical, artistic, and certain other intellectual works.” Similarly, the United States Patent and Trademark Office Web site explains that “a patent for an invention is the grant of a property right to the inventor.” Thus, most intangible assets represent a legal right that helps the owner to generate revenues.

Test Yourself

Question:

The Weddington Company reports a number of assets on its balance sheet. Which of the following should not be included as an intangible asset?

  1. Copyright
  2. Account receivable
  3. Patent
  4. Franchise

Answer:

The correct answer is choice b: Account receivable.

Explanation:

An intangible asset is one with no physical substance that provides a company with future benefit, usually a legal or contractual right, that helps to generate revenues for a period of over one year. Accounts receivable are not usually outstanding for that length of time and do not assist in the generation of future revenues. They help bring in cash that was earned in the past. Copyrights, patents, and franchises are rights that can be owned or controlled and are used to produce revenues.

The Acquisition of an Intangible

Question: Intangible assets are accounted for in a manner that is similar to property and equipment. To illustrate, assume that an automobile company is creating a series of television commercials for one of its new models. On January 1, Year One, the company pays $1 million cash to a famous musical group for the right to use a well-known song. The band holds the legal copyright on this piece of music and agrees to share that right with the automobile company so that the song can be played in one or more commercials. What accounting is made by a company that acquires an intangible asset such as a copyright?

 

Answer: The buyer of an intangible asset prepares a journal entry that is basically identical to the acquisition of inventory, land, or a machine. As with all those other assets, the intangible is recorded initially at historical cost.

Figure 11.1 January 1, Year One—Acquisition of Right to Use Copyrighted Song

Many intangible assets have defined legal lives. For example, copyrights last for seventy years beyond the creator’s life. Acquired intangibles (such as the copyright for this song) often have lives legally limited by contractual agreement. However, the true useful life of most intangibles is generally only a small number of years. Few intangibles manage to help a company generate revenues for decades. Amortization of the cost to expense should extend over the shorter of the asset’s useful life or its legal life.

Assume that this piece of music is expected to be included by the automobile company in its television commercials for the next four years. After that, a different advertising campaign will likely be started. If the straight-line method is applied (which is normal for intangible assets), annual amortization of this copyright is $250,000 ($1 million cost/4 year life).

Figure 11.2 December 31, Year One—First Year Amortization of Copyright Cost

At the end of the first year, the copyright appears on the automobile company’s balance sheet as $750,000, the remainder of its historical cost. As can be seen in Figure 11.2 “December 31, Year One—First Year Amortization of Copyright Cost”, the credit in this adjusting entry is a direct decrease in the asset account. Although establishing a separate contra account (such as accumulated amortization) is permitted, most companies simply reduce the intangible asset balance because the utility is literally shrinking. Depreciation of a building or equipment does not mean that the asset is getting smaller. A four-story building remains a four-story building throughout its life. Reducing the building account directly is not a reflection of reality. In contrast, the right to use this song does get smaller over time. The automobile company went from holding a copyright to play this music in its commercials for an expected four years to a copyright that will likely only be used for three more years. A direct reduction of the cost is more appropriate.

Intangible Assets and Fair Value

Question: In this example, the automobile company acquired the right to use this music for $1 million. That was historical cost, the figure to be reported for intangible assets on the company’s balance sheet. The number was objectively determined and the accounting straightforward. However, the artist who originally created the music (or his or her recording company) still holds the original copyright. As indicated by the sale, the rights to this music are extremely valuable. How does the creator report an intangible asset such as a copyright? Should the copyright to this piece of music now be reported by the artist at its proven value of $1 million?

 

Answer: Depending on the specific terms of the contract, the creator often continues to possess the copyright and maintains that asset on its own balance sheet. In many cases, the original artist only conveys permission to a buyer to use this music (or other intellectual work) for specific purposes or a set period of time. However, the copyright is not adjusted on the creator’s books to this $1 million value; rather, it remains at historical cost less any amortization to date. That is the reporting basis for intangible assets according to U.S. GAAP in the same way as for land, buildings, and equipment. The figure shown on the balance sheet is not increased to reflect a rise in fair value.

The reported amount shown for copyrights and other similar intangibles contains all normal and necessary costs such as attorney fees and money spent for legal filings made with appropriate authorities. Subsequently, such intangible assets sometimes become the subject of lawsuits if other parties assert claims to the same ideas and creations. The cost of a successful defense is also capitalized and then amortized over the shorter of the remaining legal life or estimated useful life of the asset. If the defense proves unsuccessful, the remaining asset balance is written off as a loss.

Test Yourself

Question:

John Doe successfully creates an invention and, on January 1, Year One, receives a patent that gives him the exclusive rights to that invention for twenty years. One year later, John Doe sells all of his rights to the patent to Nahquan Corporation for $3 million. Nahquan pays another $400,000 to a legal firm to help ensure that the right is properly transferred. Nahquan hopes to use the patent for five years and then sell it for $200,000. On December 31, Year Two, another company offers to pay Nahquan $4 million for this intangible asset but that amount is rejected as being too low. On its balance sheet at that time, what balance is reported by Nahquan for the patent?

  1. $2,560,000
  2. $2,760,000
  3. $3,040,000
  4. $3,221,053

Answer:

The correct answer is choice b: $2,760,000.

Explanation:

The capitalized cost of this asset is $3.4 million—the normal and necessary amount to acquire the patent so that it can be used to generate revenues. Annual amortization is $640,000 ([$3.4 million less $200,000 residual value] divided by five-year life). After one year, reported value is $2,760,000 ($3.4 million less $640,000). The $4 million offer does not affect the balance since it was not accepted. Amortized historical cost is the basis for financial reporting unless the value is impaired.

Talking With an Independent Auditor about International Financial Reporting Standards

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: Under U.S. GAAP, intangible assets with a finite life are reported at historical cost less any accumulated amortization recognized to date. Except in impairment cases, fair value is ignored completely. How are intangible assets reported when IFRS standards are applied?

Robert Vallejo: Unless a company chooses to revalue its intangible assets regularly (an option that is available under IFRS but that is rarely chosen because the process must then be done every reporting period), the accounting under U.S. GAAP and IFRS is basically the same. After initial recognition under IFRS, intangible assets are carried at cost less accumulated amortization (as well as any impairment losses). If an active market is available, similar intangible assets can then be adjusted to fair value but, again, that value must be updated each reporting period. Per IAS 38, Intangible Assets, the method of amortization that is used should reflect the pattern in which the asset’s future economic benefits are expected to be realized by the entity. If that pattern cannot be determined reliably, the straight-line method of amortization must be used.

Key Takeaway

The financial reporting of intangible assets has grown in significance in recent years because of the prevalence and success of businesses in industries such as technology and electronics. For the most part, intangible assets provide the owner with a legal right to use an idea, invention, artistic creation, or the like. Copyrights, patents, and trademarks are common examples. An intangible is recorded initially at historical cost. Most of these assets have a finite life, so the cost is then amortized to expense over the shorter of the legal life or estimated useful life. Consequently, intangible assets appear on the owner’s balance sheet at net book value. Amortization is usually reflected as a direct reduction in the asset balance rather than indirectly through a separate contra account. Other than this difference, accounting for intangibles resembles that used with property and equipment so that, for example, increases in value are not reported.

11.2 Balance Sheet Reporting of Intangible Assets

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Explain the theoretical rationale for using historical cost as the basis for reporting intangible assets as well as long-lived assets such as equipment.
  2. Understand that using historical cost as the accounting basis means that a company’s intangible assets can actually be worth much more than is shown on the balance sheet.
  3. Recognize that intangible assets with large monetary balances can result from acquisition either individually or through the purchase of an entire company that holds valuable intangible assets.
  4. Describe the method of recording intangible assets when the company that owns them is acquired by another company.

Reporting Historical Cost for Intangible Assets Rather Than Fair Value

Question: Much was made in earlier chapters about the importance of painting a portrait that fairly presents the financial health and future prospects of an organization. Many companies develop copyrights and other intangible assets that have incredible value but little or no actual cost.

Trademarks provide an excellent example. The golden arches that represent McDonald’s must be worth many millions, but the original design cost was probably not significant and has likely been amortized entirely to expense by now. Could the balance sheet of McDonald’s possibly be considered fairly presented if the value of its primary trademark is omitted?

Many other companies, such as Walt DisneyUPSGoogleAppleCoca-Cola, and Nike, rely on trademarks to help create awareness and brand loyalty around the world. Are a company’s reported assets not understated if the value of a trademark is ignored despite serving as a recognizable symbol to millions of potential customers? With property and equipment, this concern is not as pronounced because those assets tend to have significant costs whether bought or constructed. Internally developed trademarks and other intangibles often have little actual cost despite the possibility of gaining immense value.

 

Answer: Figures reported for intangible assets such as trademarks may indeed be vastly understated on a company’s balance sheet when compared to fair values. Decision makers who rely on financial statements need to understand what they are seeing. U.S. GAAP requires that companies follow the historical cost principle in reporting many assets. A few exceptions do exist, and several are examined at various points in this textbook. For example, historical cost may have to be abandoned when applying the lower-of-cost-or-market rule to inventory. The same is true when testing property and equipment for possible impairment losses. Those departures from historical cost were justified because the asset had lost value and financial accounting tends to be conservative. Reporting an asset at a balance in excess of its historical cost basis is much less common.

In financial accounting, what is the rationale for the prevalence of historical cost, which some might say was an obsession? As discussed in earlier chapters, cost can be reliably and objectively determined. It does not fluctuate from day to day throughout the year. It is based on an agreed-upon exchange price and reflects a resource allocation judgment made by management. Cost is not a guess, so it is less open to manipulation. Although fair value may appear to be more relevant, various parties might arrive at significantly different estimates of worth. What is the true value of the golden arches to McDonald’s as a trademark? Is it $100 million or $10 billion? Six appraisals from six experts could suggest six largely different amounts.

Plus, if the asset is not going to be sold, is the fair value of much relevance at the current time?

Cost remains the basis for reporting many assets in financial accounting, though the use of fair value has gained considerable momentum. It is not that one way is right and one way is wrong. Instead, decision makers need to understand that historical cost is the generally accepted accounting principle normally used to report long-lived assets such as intangibles. The use of historical cost does have obvious flaws, primarily that it fails to report any appreciation in value no matter how significant. Unfortunately, any alternative number that can be put forth as a replacement also has its own set of problems. At the present time, authoritative accounting literature holds that historical cost is the appropriate basis for reporting intangibles.

Even though fair value accounting seems quite appealing to many decision makers, accountants have proceeded slowly because of potential concerns. For example, the 2001 collapse of Enron Corporation was the most widely discussed accounting scandal to occur in recent decades. Many of Enron’s reporting problems began when the company got special permission (due to the unusual nature of its business) to report a number of assets at fair value (a process referred to as “mark to market”).Unique accounting rules have long existed in certain industries to address unusual circumstances. College accounting textbooks such as this one tend to focus on general rules rather than delve into the specifics of accounting as it applies to a particular industry. Because fair value was not easy to determine for many of those assets, Enron officials were able to manipulate reported figures to make the company appear especially strong and profitable.For a complete coverage of the history and ramifications of the Enron scandal, both the movie and the book The Smartest Guys in the Room are quite informative and fascinating. Investors then flocked to the company only to lose billions when Enron eventually filed for bankruptcy. A troubling incident of this magnitude makes accountants less eager to embrace the reporting of fair value except in circumstances where very legitimate amounts can be determined. For intangible assets as well as property and equipment, fair value is rarely so objective that the possibility of manipulation can be eliminated.

Test Yourself

Question:

The Consetti Company acquires a patent for $932,000 to be used in its daily operations. However, the value of this patent rises dramatically so that three years later, it is worth $3.2 million. Which of the following is not a reason that this fair value is ignored when the asset is reported on the Consetti’s balance sheet?

  1. Investors are not interested in the fair value of the patent or other intangible assets.
  2. Fair value can change often so that any one figure is not necessarily relevant for a long period of time.
  3. Different fair values might be estimated by different people.
  4. Noncurrent assets are acquired to help generate revenues and not for resale purposes.

Answer:

The correct answer is choice a: Investors are not interested in the fair value of the patent or other intangible assets.

Explanation:

Investors are likely to be interested in the fair value of all company assets because that information helps to assess the worth of the company and, hence, the possible sales price of its stock. However, accounting rules shy away from use of fair value for property and equipment as well as intangible assets. That value is no more than a guess and it can swing radically over time. Plus, if the asset is not for sale, fair value is not particularly relevant to the operations of the company.

Acquiring a Company to Gain Control of Its Intangibles

Question: Although a historical cost basis is used for intangible assets rather than fair value, Microsoft Corporation still reports $13.3 billion as “goodwill and intangible assets, net” while Yahoo! indicates similar balance sheet accounts totaling $3.9 billion. Even the size of these numbers is not particularly unusual for intangible assets in today’s economic environment. As of June 30, 2011, for example, the balance sheet for Procter & Gamble listed goodwill of $57.6 billion and trademarks and other intangible assets, net of $32.6 billion. If historical cost is often insignificant, how do companies manage to report such immense monetary amounts for their intangible assets?

 

Answer: Two possible reasons exist for a company’s intangible asset figures to grow to incredible size. First, instead of being internally developed, assets such as copyrights and patents are often acquired from outside owners. Reported asset balances then represent the historical costs of these purchases which were based on fair value at the time of the transaction. Large payments may be necessary to acquire such rights if their value has already been firmly established.

Second, MicrosoftYahoo!, and Procter & Gamble could have bought one or more entire companies so that title to a multitude of assets (including a possible plethora of intangibles) was obtained in a single transaction. In fact, such acquisitions often occur specifically because one company wants to gain valuable intangibles owned by another. In February 2008, Microsoft offered over $44 billion in hopes of purchasing Yahoo! for exactly that reason. Yahoo! certainly did not hold property and equipment worth $44 billion. Microsoft was primarily interested in acquiring a wide variety of intangibles owned by Yahoo! Although this proposed takeover was never completed, the sheer size of the bid demonstrates the staggering value of the intangible assets that companies often possess today.

If a company buys a single intangible asset directly from its owner, the financial reporting follows the pattern previously described. Whether the asset is a trademark, franchise, copyright, patent, or the like, it is reported at the amount paid. That cost is then amortized over the shorter of its estimated useful life or legal life. Intangible assets that do not have finite lives are not amortized and will be discussed later in this chapter.

Reporting the assigned cost of intangible assets acquired when one company (often referred to as “the parent”) buys another company (“the subsidiary”) is a complex issue discussed in more detail in Chapter 12 “In a Set of Financial Statements, What Information Is Conveyed about Equity Investments?”. In simple terms, the subsidiary’s assets (inventory, land, buildings, equipment and the like) are valued and recorded at that amount by the parent as the new owner. The subsidiary’s assets and liabilities are consolidated with those of the parent. In this process, each intangible asset held by the subsidiary that meets certain requirements is identified and recorded by the parent at its fair value. The assumption is that a portion of the price conveyed to purchase the subsidiary is being paid to obtain these intangible assets.

To illustrate, assume Big Company pays $10 million in cash to buy all the capital stock of Little Company. Consolidated financial statements will now be necessary. Little owns three intangibles (perhaps a copyright, patent, and trademark) that are each worth $1 million. Little also holds land worth $7 million but has no liabilities. Little’s previous net book value for these assets is not relevant to Big, the new owner.

Following the takeover of Little, Big reports each of the intangibles on its balance sheet at its cost of $1 million (and the land at $7 million). The acquisition price is assumed to be the historical cost paid by Big to obtain these assets. A parent that buys many subsidiaries will frequently report large intangible asset balances as a result. When Big purchases Little Company, it is really gaining control of all these assets and records the transaction as shown in Figure 11.3 “Big Company Buys Little Company, Which Holds Assets with These Values”.

Figure 11.3 Big Company Buys Little Company, Which Holds Assets with These Values

Test Yourself

Question:

The Tiny Company creates a logo for a product line and gets a copyright on it. The entire cost is $40,000, and the logo is expected to have a useful life of ten years. One year later, Gigantic Company buys all the ownership stock of Tiny Company. At that point in time, the logo has gained national prominence and is thought to be worth $400,000. If Gigantic prepares a consolidated balance sheet immediately after acquiring Tiny, what is reported for this logo?

  1. $36,000
  2. $400,000
  3. $436,000
  4. $440,000

Answer:

The correct answer is choice b: $400,000.

Explanation:

Because Gigantic bought Tiny, the assumption is made that a portion of the price that was paid for Tiny was made to acquire the logo at its fair value. Thus, to Gigantic, the historic cost of this asset is $400,000. The cost to Tiny is no longer relevant. The $400,000 will then be amortized to expense over the remaining life of the intangible.

Key Takeaway

Many intangible assets (such as trademarks and copyrights) are shown on the balance sheet of their creator at a value significantly below actual worth. They are reported at historical cost less all amortization since the date of acquisition. Development cost can be relatively low in comparison to the eventual worth of the right. However, because of conservatism, the amount reported for these assets is not raised to fair value. Such numbers are subjective and open to sudden fluctuations. Furthermore, if an intangible asset is not held for sale, fair value is of questionable relevance to current operations. Companies, though, often pay large amounts either to buy intangibles or entire companies that hold valuable intangibles. In accounting for a parent’s acquisition of a subsidiary, the amount paid is assigned to the identifiable assets of the subsidiary (both tangible and intangible) based on fair value at that date.

11.3 Recognizing Intangible Assets Owned by a Subsidiary

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Understand that only subsidiary intangible assets that meet either of two specific criteria are recognized separately by a parent following an acquisition.
  2. Explain the meaning of the asset goodwill.
  3. Compute and record the amount to be reported as goodwill on a consolidated balance sheet when a parent acquires another company as a subsidiary.
  4. Understand that amounts attributed to goodwill are not amortized to expense but rather are checked periodically for impairment of value.

Criteria for Recognizing Intangible Assets

Question: Most major businesses report some amount of intangible assets. These can be developed internally, bought individually, or obtained as part of the purchase of an entire company. Larger amounts usually come from the acquisition of a subsidiary by a parent. The accountant faces the challenge of determining which costs to capitalize and which costs to expense. Because of their very nature, identifying intangible assets is more difficult than identifying tangible assets. A computer is obviously an asset, but is a list of client names inside of that computer also an asset?

For example, when one company buys another, the subsidiary is often holding rights to numerous intangibles. As mentioned previously, company acquisitions often take place to gain those rights. The parent then places the assets that qualify on its balance sheet at fair value to show that a portion of the amount paid for the subsidiary was the equivalent of an acquisition price for these items. That is a major reason why companies such as Microsoft and Procter & Gamble report billions of dollars in intangibles. They have probably gained ownership of many of these assets by acquiring entire companies.

However, according to U.S. GAAP, certain requirements have to be met before intangibles are recognized as assets. What criteria must be satisfied for a company to record an intangible as an asset? A business could very well spend millions of dollars for scores of intangibles: patents, copyrights, databases, smart employees, loyal customers, logos, and the like. Which of these intangibles should actually be recognized on a balance sheet as an asset?

 

Answer: The rules for reporting intangible assets are best demonstrated through the acquisition of a subsidiary by a parent because large amounts are often spent for numerous items that might qualify as assets. In establishing rules for consolidated financial statements, FASB has stated that a parent company must identify all intangible assets held by a subsidiary on the date of acquisition. The fair value of each of these intangibles is recorded by the parent as an asset but only if contractual or other legal rights have been gained or the intangible can be separated and sold. This authoritative guideline serves as a minimum standard for recognition of intangible assets:

  1. Contractual or other legal rights have been gained or
  2. The intangible can be separated from the subsidiary and sold

Patents, copyrights, trademarks, and franchises clearly meet the first of these criteria. Legal rights are held for patents, copyrights, and trademarks while contractual rights allow the owner to operate franchises. By acquiring the subsidiary, the parent now controls these same rights and should record them on the consolidated balance sheet at fair value.

Other intangibles that can be separated from the subsidiary and sold should also be consolidated at fair value. For example, an acquired company might have a database containing extensive information about its customers. After purchasing the subsidiary, this information could be separated from that company and sold. Thus, on the date the subsidiary is purchased, the parent recognizes this database as an intangible asset at fair value to reflect the portion of the acquisition price paid to obtain it.

Test Yourself

Question:

Tree Company buys all the ownership stock of Leaf Company. Leaf holds one intangible worth $10,000, but it is not separately consolidated by Tree after the purchase. What is the most likely reason that this intangible was not included by the new parent?

  1. Leaf owned the intangible rather than Tree.
  2. The intangible did not have a finite life and, therefore, could not be viewed as an asset.
  3. Leaf must sell the intangible directly to Tree before it can be reported by the parent.
  4. Leaf did not have contractual or legal rights to the intangible and it could not be separated from the company and sold.

Answer:

The correct answer is choice d: Leaf did not have contractual or legal rights to the intangible and it could not be separated from the company and sold.

Explanation:

To be recognized as an intangible asset after a corporate takeover, FASB has set guidelines. Either the company must have contractual or legal rights in the intangible asset or it must be an item that could be separated from Leaf and sold. Without meeting one of these criteria, it is uncertain as to whether the subsidiary actually possesses something that will have value to the consolidated company.

Recognition of Goodwill

Question: When one company buys another, payment amounts will likely be negotiated to compensate the seller for intangibles where contractual or legal rights are held or where the asset can be separated and then sold. Thus, parent companies who buy subsidiaries (especially in industries such as technology) will likely recognize significant intangible asset balances on a subsequently consolidated balance sheet.

However, some intangibles have significant value but fail to meet either of these two criteria. Customer loyalty, for example, is vitally important to the future profitability of a business, but neither contractual nor legal rights are present and loyalty cannot be separated from a company and sold. Hence, customer loyalty is not reported as an intangible asset regardless of its worth. Much the same can be said for brilliant and creative employees. A value exists but neither rule for recognition is met.

During negotiations, the owners of a company that is being acquired will argue for a higher price if attributes such as these are in place because they provide increased profitability in the future. The amount paid to obtain a subsidiary can be impacted although these intangibles do not meet the criteria for separate reporting as assets. How is this additional acquisition cost reported by the parent in producing consolidated financial statements?

To illustrate, assume Giant Corporation pays $16 million to acquire Tiny Corporation. The subsidiary owns property and equipment worth $4 million. It also holds patents worth $6 million, a database worth $2 million, and copyrights worth $3 million. The total value of these four assets is only $15 million. For convenience, assume Tiny has no liabilities. Assume that Giant agrees to pay the extra $1 million because the subsidiary has customer loyalty valued at $600,000 and a talented workforce worth $400,000. How is this additional $1 million reported on consolidated financial statements after the takeover? What recording is appropriate when a parent buys a subsidiary and pays an extra amount because valuable intangibles are present that do not meet the criteria for separate reporting?

 

Answer: Every subsidiary intangible (such as patents, copyrights, and databases) that meets either of the official criteria is consolidated by the parent as an asset at fair value. Any excess price paid over the total fair value of these recorded assets (the extra $1 million in this example) is also reported as an asset. It has a definite cost and an expected future value. The term that has long been used to report an amount paid to acquire a company that exceeded all the identified and recorded assets is goodwillThe price paid by one company to acquire another that is in excess of the fair value of net identifiable assets and liabilities; this cost is often associated with intangibles that do not meet the criteria for accounting recognition, such as employee expertise and customer loyalty.. Some amount of goodwill is recognized as a result of virtually all corporate acquisitions. In this example, it specifically reflects the value of the customer loyalty and the quality of the subsidiary’s workforce.

If Giant pays $16 million for the stock of Tiny when its reportable assets have a value of only $15 million, the entry shown in Figure 11.4 “Giant Company Buys Tiny Company—$1 Million Paid in Excess of Fair Value of Identifiable Assets” is made by Giant to consolidate the two companies. The additional payment of $1 million is labeled as goodwill, which will then be reported along with the other intangible assets.

Figure 11.4 Giant Company Buys Tiny Company—$1 Million Paid in Excess of Fair Value of Identifiable Assets

Excess Payment for a Subsidiary Not Identified with an Intangible

Question: In the previous illustration, Giant (the parent) paid an extra $1 million for specified intangibles. However, the subsidiary’s customer loyalty and talented workforce could not be recognized separately as assets because they met neither of the required criteria. Instead, a goodwill balance was created.

Will the reporting be any different if the parent simply paid this amount as a result of intense negotiations? Assume, for example, that Giant agreed to pay the additional $1 million to obtain Tiny solely because that company’s owners refused to sell for less. That often happens in the business world. Giant believed that the $16 million price was still a good investment even though it required $1 million more than the value of the identified assets (tangible and intangible). If a parent pays an additional amount to purchase a subsidiary without a specific rationale, is this cost still recorded as goodwill?

 

Answer: The acquisition of one company by another can require months of bargaining between the parties. One company wants to collect as much as possible; the other wants to pay as little as possible. Compromise is frequently necessary to arrive at a figure that both parties are willing to accept. In most cases, the parent has to pay more than the sum of the value of all individual assets to entice the owners of the other company to sell.

Sometimes, as in the initial example, the reason for the added payment is apparent (customer loyalty and talented workforce). More likely, the increased amount is simply necessary in order to make the deal happen. Whenever an extra cost must be expended to gain control of a subsidiary, it is labeled by the parent as an asset known as goodwill. The rationale does not impact the accounting. Any additional acquisition price that was required to obtain a subsidiary appears in the parent’s balance sheet as goodwill and is shown as an intangible asset.

Test Yourself

Question:

Lance Company has three assets. The first is land with a cost of $700,000 and a fair value of $1 million. The second is a building with a net book value of $2 million but a fair value of $3 million. Finally, the company has a trademark that has no reported value (it has been fully depreciated) but is worth $400,000. The Empire Company offers $4.4 million for all the ownership shares of Lance. Lance owners counter with a price of $5.1 million. After nine days of negotiations, Empire pays $4.7 million to acquire Lance Company. When the financial statements of the two companies are consolidated, what amount will be reported as goodwill?

  1. Zero
  2. $300,000
  3. $700,000
  4. $2 million

Answer:

The correct answer is choice b: $300,000.

Explanation:

On consolidated statements after the takeover, Empire reports the land, building, and trademark at their fair values, which total $4.4 million. However, Empire paid an additional $300,000 ($4.7 million less $4.4 million) to convince the owners of Lance to sell. This payment is reported as the intangible asset goodwill. In this situation, it is not attributed to any specific value such as employee loyalty. It is the amount in excess of the individual fair values that the parent had to pay.

Accounting for Goodwill Over Time

Question: Buildings, equipment, patents, databases, and the like are all assets. They have reported costs that will be assigned to expense over an expected life as they help generate revenues. Goodwill is a different type of asset. It represents either (a) a subsidiary attribute (such as customer loyalty) that is too nebulous to be recognized specifically as an asset or (b) an extra payment made by the parent to acquire the subsidiary as a result of the negotiation process. What happens to a cost identified as the asset goodwill after the date a subsidiary is acquired?

How do MicrosoftYahoo!, or Procter & Gamble account for their large goodwill balances over time? Is this asset like land that simply continues to be reported at historical cost potentially forever or, possibly, like equipment that is depreciated systematically over some anticipated useful life?

 

Answer: Because goodwill is the one asset on a balance sheet that is not tied to an identifiable benefit, no attempt is ever made to determine an anticipated life. Consequently, the assigned cost is not amortized to expense. A goodwill balance can remain unchanged on a consolidated balance sheet for decades after a subsidiary is purchased. However, the reported figure is reduced immediately if its value is ever judged to be impaired. Attributes such as customer loyalty or a talented workforce might continue in place for years or disappear completely in a short period of time. If goodwill is merely a premium paid to acquire a subsidiary, the justification for that excess amount could vanish because of poor management decisions or environmental factors. The value of all assets is tentative but probably none is more so than goodwill.

Although a cost recorded as goodwill is not amortized over time, its ongoing worth is not assumed. Instead, a test to check for any loss of that value is performed periodically. This verification process is more complex than can be covered in an introductory course. The result, though, is important to understand. In the event that the goodwill associated with a subsidiary is ever found to be worth less than its reported balance, an impairment loss is recorded. Although not identical, the accounting is similar in some ways to the impairment test for land, buildings, and equipment demonstrated previously.

In 2000, Time Warner and America Online (AOL) merged. Because of the perceived benefit of combining these two companies, a huge premium was paid and reported as goodwill on the consolidated balance sheet. A mere two years later, it was obvious that the anticipated synergies from this transaction had not developed as expected. In simple terms, too much money had been paid by the owners to create the merger. The value of the combined companies had not managed to achieve overly optimistic projections. Consequently, goodwill was reduced in 2002 by nearly $100 billion. A loss of that amount was reported by the consolidated company. The goodwill account was not amortized to expense, but the impairment of its value had to be recognized.

Test Yourself

Question:

Giant Company buys all the outstanding stock of Small Company on January 1, Year One. Subsequently, on the consolidated balance sheet as of December 31, Year Five, Giant and Consolidated Subsidiary reported a goodwill balance of $300,000. Which of the following is most likely to be true?

  1. $300,000 is the value of Small on this date in excess of the value of its assets minus its liabilities.
  2. $300,000 is the excess amount paid by Giant to acquire Small unless the value of that figure has become impaired since the purchase.
  3. $300,000 is the excess amount paid by Giant to acquire Small less any amortization since January 1, Year One.
  4. $300,000 is the fair value of the goodwill on December 31, Year Five.

Answer:

The correct answer is choice b: $300,000 is the excess amount paid by Giant to acquire Small unless the value of that figure has become impaired since the purchase.

Explanation:

Goodwill is initially recorded as the excess amount paid over the value of the identifiable assets and liabilities when a subsidiary is acquired. This figure stays unchanged because it is not subject to amortization unless the value is ever judged to have been impaired. If so, the recorded amount is reduced to recognize this loss of value.

Key Takeaway

When a parent acquires another company, all intangibles held by that subsidiary must be identified and consolidated at fair value if either of two criteria is met. Reporting these assets is necessary if legal or contractual rights are held or the intangible can be separated from the subsidiary and sold. Additional amounts are often included in the acquisition price of a subsidiary to compensate for intangibles (such as customer loyalty) that do not meet either of these criteria. An extra payment may also be necessary simply to entice the owner to sell. In either situation, this additional cost is reported as goodwill, an intangible asset that then appears on the consolidated balance sheet. Goodwill does not have an expected useful life. Consequently, the amount assigned to this intangible asset is not amortized to expense over time. Instead, the reported balance is checked periodically for impairment with a loss recognized if the value ever declines.

11.4 Accounting for Research and Development

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Define the terms “research” and “development.”
  2. Explain the problem that uncertainty creates for accountants in reporting research and development costs.
  3. Understand the required method of reporting research and development costs according to U.S. GAAP.
  4. Discuss the advantages of reporting research and development costs in the manner required by U.S. GAAP.
  5. Recognize that many companies report asset totals that are vastly understated as a result of the authoritative handling of research and development costs.

Reporting Research and Development Costs

Question: Many companies create internally developed intangibles such as copyrights and trademarks. One common intangible of this type is a patent, the right to make use of an invention. The creation and nurturing of an idea so that it can eventually earn a patent and be offerred for sale often takes years. The monetary amounts spent in this way to arrive at new marketable products are often enormous. The risk of failure is always present.

Such expenditures are essential to the future success of a great many companies. In 2010 alone, Intel reported spending $6.6 billion on researchThe attempt to find new knowledge with the hope that the results will eventually be useful in creating new products or services or significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. and developmentThe translation of new knowledge into actual products or services or into significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. in hopes of discovering new products to patent and sell. During the same one-year period, Bristol-Myers Squibb incurred costs of $3.6 billion on research and development. Those are clearly not inconsequential amounts. What is meant by the term “research”? What is meant by the term “development”? If a company such as Intel or Bristol-Myers Squibb spends billions on research and development each year, what accounting is appropriate? Should an asset or expense be recognized or possibly some combination? The outcome is uncertain, but the money was spent under the assumption that future economic benefits would be derived.

For example, assume that a technological company or a pharmaceutical company spends $1 million in Year One to do research on Future Product A. The company then spends another $1 million during the same period on development costs for Future Product A. At the end of this year, officials believe that a patent is 80 percent likely for Future Product A. If the patent is received, sales can be made.

Also during that time, the company spends another $1 million in research and $1 million in development in connection with Future Product B. However, at year’s end, the same officials are less optimistic about these results. They believe that only a 30 percent chance exists that this second product will ever receive a patent so that it can be used to generate revenues. According to U.S. GAAP, what reporting is appropriate for the cost of these two projects?

 

Answer: Definitions are easy to recite.

  • Research is any attempt made to find new knowledge with the hope that those results will eventually be useful in creating new products or services or significant improvements in existing products or services.
  • Development is the natural next step. It is the translation of that new knowledge into actual products or services or into significant improvements in existing products or services.

In simple terms, research is the effort expended to create new ideas; development is the process of turning those new ideas into saleable products.

However, the reporting of research and development costs poses incredibly difficult challenges for the accountant. As can be seen with Intel and Bristol-Myers Squibb, the quantity of these expenditures is often massive because of the essential role that new ideas and products play in the future success of many organizations. Unfortunately, significant uncertainty is inherent in virtually all such endeavors. The probability that any research and development cost will eventually lead to a successful product can be impossible to determine for years. Furthermore, any estimation of the outcome of such work is open to manipulation. Often the only piece of information that is known with certainty is the amount that has been spent.

Thus, except for some relatively minor exceptions, all research and development costs are expensed as incurred according to U.S. GAAP. The probability for success is not viewed as relevant to this reporting. Standardization is very apparent. All companies provide the same information in the same manner. The total cost incurred each period for research and development appears on the income statement as an expense regardless of the chance for success.

Consequently, the accounting for Future Product A and Future Product B is identical. Although one is 80 percent likely to be successful whereas the other is only 30 percent likely, all research and development costs for both are expensed as incurred. No asset is reported despite the possibility of future benefits. The rigidity of this rule comes from the inherent uncertainty as to whether revenues will ever be generated and, if so, for how long. Rather than trying to anticipate success, the conservatism found in financial accounting simply expenses all such costs as incurred. The percentages associated with the likelihood of receiving a patent and generating future revenues are ignored.

Two major advantages are provided by this approach. First, the amount spent by a company on research and development each period is easy to determine and then compare with previous years and with other similar businesses. Most decision makers are interested in the amount invested in the search for new ideas and products and that information is readily apparent. Second, the possibility for manipulation is virtually eliminated. No distinction is drawn between a likely success and a probable failure. No reporting advantage is achieved by maneuvering the estimation of a profitable outcome.

Test Yourself

Question:

On its income statement for the current year, the Acme Corporation reported an expense for research and development of $236 million. What information is conveyed by this balance?

  1. It is an amortization expense associated with patents, copyrights, and other intangible assets.
  2. It is the amount spent on projects that failed during the year.
  3. It is the amount spent on all research and development activities during the year.
  4. It is the amount spent on all projects during the year that did not become at least 50 percent likely of achieving status as an asset.

Answer:

The correct answer is choice c: It is the amount spent on all research and development activities during the year.

Explanation:

All research and development costs are expensed as incurred. No asset balances are recognized. In that way, the amount invested by a company each year in connection with this vital activity is evident to decision makers.

Research and Development Costs and the Impact on the Balance Sheet

Question: Billions of dollars are spent each year on research and development in hopes of creating new products that could be sold in the future. Company officials would never risk this money unless they believed that a reasonable chance existed for recouping such huge investments. However, whether success is 100 percent likely or only 2 percent, no assets are reported on the balance sheet for these costs. That is U.S. GAAP.

Because all amounts spent on research and development are expensed automatically, are the assets reported by companies in industries such as technology and pharmaceuticals not omitting many of their most valuable future benefits? If a company spends $5 billion to develop a new drug or electronic device that becomes worth $11 billion, does the reporting of no asset make sense? Does that approach provide a fair portrait of the company?

 

Answer: Even a student in an introductory accounting course can quickly recognize the problems created by a rule requiring that all research and development costs be expensed as incurred. Companies in technology, pharmaceutical, and many other industries must exclude items of significant value from their balance sheets by following U.S. GAAP. While this approach is conservative, consistent, and allows for comparability, the rationale is confusing. The balance sheet hardly paints a fair portrait of the assets being held. Expensing research and development costs also violates the matching principle. These expenditures are made in the hopes of generating future revenues but the expense is recorded immediately before any revenues have been earned.

Capitalizing these costs so that they are reported as assets is logical but measuring the value of future benefits is extremely challenging. Without authoritative guidance, the extreme uncertainty of such projects would leave the accountant in a precarious position. The temptation would be to tailor the reporting to make the company look as good as possible. U.S. GAAP “solves” the problem by eliminating the need for any judgment by the accountant. All costs are expensed. No rule could be simpler to apply.

Consequently, any decision maker evaluating a company that invests heavily in research and development needs to recognize that the assets appearing on the balance sheet are incomplete. Such companies spend money to create future benefits that are not being reported. The wisdom of that approach has long been debated but it is the rule under U.S. GAAP. Difficult estimates are not needed and the possibility of manipulation is avoided.

Talking with an Independent Auditor about International Financial Reporting Standards

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

 

Question: Virtually without exception, U.S. GAAP requires that all research and development expenditures must be expensed as incurred. This requirement has existed for over thirty years. Does IFRS handle research and development costs in the same manner?

Robert Vallejo: This is one of the best examples of differences between IFRS and U.S. GAAP. If specified criteria are met, IFRS requires the capitalization of development costs. These guidelines help determine when a project moves from the research stage into the development stage. However, once the development stage commences, the costs are capitalized and amortized over the anticipated useful life. When companies first adopt IFRS, this change will require some effort, particularly if development costs are significant. Changing to IFRS will have a substantial impact on reported net income. This issue will need to be considered early in a conversion to IFRS, as recasting prior period information taking into account the capitalization of development costs will be difficult.

The difference between U.S. GAAP and IFRS is not a question of right or wrong but rather an example of differing yet valid viewpoints. U.S. GAAP prefers not to address the uncertainty inherent in research and development programs but rather to focus on comparability of amounts spent (between years and between companies). IFRS, on the other hand, takes a view that the expenses should be matched with the benefits to be obtained in future periods.

Key Takeaway

Research and development costs include all amounts spent to create new ideas and then turn them into products that can be sold to generate revenue. Because success in these endeavors is highly uncertain, accounting has long faced the challenge of determining whether such costs should be capitalized or expensed. U.S. GAAP requires that all research and development costs (with a few minor exceptions) be expensed as incurred. This official standard does prevent manipulation and provides decision makers with the monetary amount spent by management each year for this essential function. However, this method of accounting means that companies (especially in certain industries) often fail to show some of their most important assets on their balance sheets. Despite the obvious value of these assets, the cost is expensed entirely.

11.5 Acquiring an Asset with Future Cash Payments

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Realize that if payments to acquire an asset are delayed into the future, part of the total cash amount is attributed to the purchase of the asset with the rest deemed to be interest.
  2. Recognize that a reasonable rate of interest on a long-term debt can be stated explicitly in the contract and paid when due so that no present value computation is needed.
  3. Record the acquisition of an intangible asset based on a present value computation whenever payments are made over a period of years and no explicit interest is included in those payments.
  4. Define the term “compounding.”
  5. Compute interest to be recognized each period when a long-term debt was recorded using a present value computation.
  6. Differentiate between an annuity due and an ordinary annuity.

Purchases Made with Future Cash Payments

Question: A company buys a patent from an inventor on January 1, Year One, for $1 million to be paid immediately. The accounting here is straightforward; the patent is recognized as an intangible asset and reported at the historical cost of $1 million. Accounting rules are clear on the handling of such acquisitions.

Assume, instead, that the company offers to pay this $1 million but not until five years have passed. The seller agrees to that proposal. The purchase is made now, but payment is delayed. Is the $1 million still being paid solely for the patent? Does the entire $1 million reflect the historical cost of this intangible? What reporting is appropriate if an asset such as a patent, building, or land is bought but payment will not take place for several years? In such cases, how is historical cost determined?

 

Answer: More than forty years ago, the accounting body that was viewed as authoritative at the time ruled that when cash is paid for a purchaseSimilar rules apply when an asset is sold and the money is to be collected over a period of future years. For convenience, the illustrations in this chapter will focus solely on cash payments made in an acquisition. over an extended period of time, two distinct reasons for the payments always exist.The Accounting Principles Board (APB) was the primary group in charge of creating U.S. GAAP from 1962 until 1973 when it was replaced by the Financial Accounting Standards Board (FASB). During those years, the APB produced thirty-one opinions. Its Opinion 21, “Interest of Receivables and Payables” was issued in August 1971 and established the rules described here. Within the new Accounting Standards Codification, information on the reporting of interest can be found at FASB ASC 835-30.

  • The first is obviously the acquisition of the property such as the patent in this example.
  • The second is interestThe charge for using money over time, often associated with long-term loans; even if not specifically mentioned in the debt agreement, financial accounting rules require it to be computed and reported based on a reasonable rate.. Interest is the charge for the use of money over time.

This rule assumes that no reasonable seller would allow cash payments to be spread over several years without some interest charge being factored into the negotiated amounts. In other words, interest (the charge for the use of the money over time) is included whether it can be seen or not. The accounting demonstrated here is the result of that assertion.

In many purchases where payments are made over time, interest payments are explicitly included. For example, the contract to buy this patent could have required payment of the $1 million after five years plus interest at a 7 percent rate to be paid each year. With those terms, the accounting process is not complicated. The $1 million is the historical cost of the patent while the annual $70,000 payments ($1 million × 7 percent) are recorded each year by the buyer as interest expense. The two amounts are clearly differentiated based on the terms of the agreement.

A theoretical problem arises if interest is not identified in the contract. In the current illustration, assume that the company agrees to make a single $1 million payment in five years with no mention of interest. According to U.S. GAAP, interest is still present and must be recognized because the conveyance of cash has been delayed. This means that only part of the $1 million is actually paid for the patent with the rest serving as interest. Authoritative accounting rules hold that an interest charge is always present when payment is put off into the future. Payment has been deferred for five years; some part of that amount serves to compensate the seller for having to wait to receive the money.

However, the specific allocation of the $1 million between patent and interest is not readily apparent. To calculate the interest included within the price, an introduction to present valueThe amount associated with cash flows after all future interest—computed at a reasonable rate—has been mathematically removed; this figure is the principal of those future cash flows. computations is necessary.

In simple terms, the present value of future cash flows is the amount left after all future interest is removed (hence the term “present value”). The present value is the portion within the $1 million that is being paid for the patent. The remainder will be recognized as interest expense over the five-year period until payment is made.

To determine the present value of future cash flows, a reasonable interest rate is needed. Then, the amount of interest for these five years can be mathematically calculated and removed. An appropriate interest rate is often viewed as the one the buyer would be charged if the money were borrowed from a local bank.

Assume here that 10 percent is a reasonable annual interest rate. Fortunately, present value conversion factors have already been mechanically computed. They can serve to remove the future amount of interest so that only the present value (the amount paid for the patent) is left. The formula to determine the present value of $1 at a designated point in the future is $1 divided by (1 + i) raised to the nth power with “n” being the number of periods and “i” the appropriate interest rate. In this case, because payment is due in five years, the present value $1 is $1/(1.10)5, or 0.62092. This factor can then be multiplied by the actual cash payment to determine its present value.

In an Excel spreadsheet, the present value of $1 at 10 percent for five years is derived by entering the following formula into one of the cells: =PV(.10,5,0,1). Thus, the present value of $1,000,000 is found in Excel by entering =PV(.10,5,0,1000000).

Regardless of the method being applied, if $1 is paid in five years for an asset and a reasonable rate of interest is 10 percent per year, then the $0.62 (rounded) present value is the portion being paid for the asset with the remaining $0.38 representing interest for those years. The present value computation mathematically determines the interest and then removes it to leave the cost of the asset.

Predetermined present value tables are available as well as calculators and computer spreadsheets that make this computation relatively easy. Present value tables can be found at the end of this book as well as through Internet links provided at appropriate spots throughout the chapters.

On a table created to provide the present value of a single amount of $1, the factor is found by looking under the specific interest rate column (10 percent) at the line for the number of applicable time periods (five).

The present value today of paying $1 million in five years assuming a 10 percent annual interest rate is $1 million times 0.62092 or $620,920. This is the cost before any future interest is accrued over time. Mathematically, the interest for these five years has been computed and removed to arrive at this figure. The remainder of the payment ($379,080) will be reported as interest expense by the buyer over the subsequent five years using a 10 percent annual rate. The total ($620,920 for the patent plus $379,080 in interest) equals the $1 million payment.

The journal entries for Year One are shown in Figure 11.5 “Present Value—Acquisition of Patent with Future Payment of Cash and Recognition of Year One Interest”. On January 1, the patent and the liability are reported at present value. No time has passed so no interest is recognized. However, at the end of that first year, interest expense of $62,092 should be reported. That amount is 10 percent of the liability’s principal balance for that year ($620,920).The effective rate method of computing interest is demonstrated here. The principal balance is multiplied by the reasonable interest rate to get the amount of interest to be recorded each period. The effective rate method is the preferred approach according to U.S. GAAP. In Chapter 14 “In a Set of Financial Statements, What Information Is Conveyed about Noncurrent Liabilities Such as Bonds?”, an alternative method known as the straight-line method is also demonstrated. It is also allowed by U.S. GAAP if the differences are not viewed as material.

Figure 11.5 Present Value—Acquisition of Patent with Future Payment of Cash and Recognition of Year One Interest

Notice in the December 31 entry that no interest is paid on that date. Payment of this additional charge actually occurs in five years when $1 million is paid and not just $620,920. Because interest was recognized in Year One but not paid, the amount of the liability (the principal) has grown. Increasing a debt to reflect the accrual of interest is referred to as “compounding.” Whenever interest is recognized but not paid, it is compounded which means that it is added to the principal of the liability.

In the second year, the expense to be recognized is higher because the principal has increased from $620,920 to $683,012 ($620,920 plus $62,092) as a result of compounding the Year One interest. The ongoing compounding raises the principal each year so that the interest expense also increases as can be seen in the series of entries in Figure 11.6 “Present Value—Recognition and Compounding of Interest”.

Figure 11.6 Present Value—Recognition and Compounding of InterestIf the computations and entries are all correct, the liability balance will grow to $1 million at the end of five years. In the present value computation, the interest was removed at a 10 percent annual rate and then put back into the liability each year through compounding at the same rate. Because figures are rounded in these computations, the final interest journal entry may have to be adjusted by a few dollars to arrive at the $1 million total.

These journal entries show that three goals are achieved by this reporting process.

  • The patent is recorded at its historical cost of $620,920, the total amount to be paid less a reasonable interest rate for the five year delay until payment is made.
  • The compounding process adds the interest back into the liability that was removed in determining the present value so that the reported balance returns to $1 million as of the due date.
  • Interest expense of $379,080 is recognized over the five-year period ($62,092 + $68,301 + $75,131 + $82,644 + $90,912). Although interest was not mentioned in the contract, U.S. GAAP requires it to be computed and reported over these five years.

Test Yourself

Question:

Osgood Company buys an intangible asset on January 1, Year One, for $300,000. The company will make this payment at the end of Year Three. In the interim, interest payments of $27,000 will be made each year based on a reasonable rate. On January 1, Year One, what amount is reported for the intangible and the liability?

  1. $300,000
  2. The present value of $300,000
  3. The present value of $327,000
  4. The present value of $381,000

Answer:

The correct answer is choice a: $300,000.

Explanation:

A reasonable interest rate is being paid, so although payment to acquire the intangible has been delayed for three years, there is no reason to compute the present value of the cash flows. Present value is only used when a reasonable interest is not explicitly stated and paid. The $300,000 amount is the principal amount and the $27,000 annual payments are the interest.

Test Yourself

Question:

Weisz Company buys an intangible asset on January 1, Year One, for $300,000 to be paid in exactly three years. No additional amounts are mentioned in the contract although a reasonable interest rate is 8 percent per year. The present value of $1 at an 8 percent rate to be paid at the end of a three-year period is $0.79383. What does the company report on the date of acquisition?

  1. Asset of $238,149 and liability of $238,149
  2. Asset of $300,000 and liability of $238,149
  3. Asset of $238,149 and liability of $300,000
  4. Asset of $300,000 and liability of $300,000

Answer:

The correct answer is choice a: Asset of $238,149 and liability of $238,149.

Explanation:

Because a reasonable interest rate is not being paid, the initial acquisition (both the cost of the asset and the principal of the liability) is recorded at the present value of the future cash flows ($238,149 or $300,000 × 0.79383). Present value computes the interest for three years at an 8 percent rate and then removes it to leave the amount paid, here, for the intangible asset.

Test Yourself

Question:

Tylo Company buys an intangible asset on January 1, Year One, for a single $400,000 payment in exactly four years with no additional cash being paid in the interim. A reasonable interest rate is 10 percent per year. The present value of $1 at a 10 percent rate to be paid at the end of a four-year period is $0.68301. How does the annual recognition of interest over those four years impact the recorded amount of the intangible asset?

  1. It has no effect.
  2. It increases the reported asset by $6,830.10 per year.
  3. It increases the reported asset by $27,320.40 per year.
  4. It increases the reported asset by $40,000.00 per year.

Answer:

The correct answer is choice a: It has no effect.

Explanation:

Interest will be recognized each year based on the reasonable rate of 10 percent. However, that impacts the liability balance and has no impact on the asset. The asset is recorded initially at present value and that cost is then amortized to expense over the useful life of the asset (unless the asset does not have a finite life). The interest is recorded each year as an expense and compounded to increase the liability.

Test Yourself

Question:

Guthrie Company buys an intangible asset on January 1, Year One, for a single $500,000 payment in exactly five years with no additional cash being paid in the interim. A reasonable interest rate is 10 percent per year. The present value of $1 at a 10 percent rate to be paid at the end of a five-year period is $0.62092. What interest is recognized in each of the first two years?

  1. Zero in Year One and Zero in Year Two
  2. $31,046 in Year One and $31,046 in Year Two
  3. $31,046 in Year One and $34,150.60 in Year Two
  4. $50,000 in Year One and $50,000 in Year Two

Answer:

The correct answer is choice c: $31,046 in Year One and $34,150.60 in Year Two.

Explanation:

Because a reasonable interest rate is not paid, the liability for this $500,000 payment is recorded initially at its present value of $310,460 ($500,000 × 0.62092). Interest for the first year is 10 percent of this principal or $31,046 ($310,460 × 10 percent). No interest is paid at that time so this entire amount is compounded raising the principal to $341,506 ($310,460 plus $31,046). Interest expense for the second year is $34,150.60 based on the reasonable 10 percent annual rate.

Test Yourself

Question:

Laettner Company buys an intangible asset on January 1, Year One, for $200,000 to be paid in exactly five years with no additional cash being paid in the interim. A reasonable interest rate is 10 percent per year. The present value of $1 at 10 percent rate to be paid at the end of a five-year period is $0.62092. What does Laettner Company report on its December 31, Year Two balance sheet for this liability?

  1. $124,184.00
  2. $136,602.40
  3. $150,262.64
  4. $200,000.00

Answer:

The correct answer is choice c: $150,262.64.

Explanation:

Because reasonable interest is not paid, the liability is recorded at present value ($200,000 × 0.62092 or $124,184). After one year, interest of $12,418.40 ($124,184 × 10 percent) is recognized. It is not paid but compounded raising the principal to $136,602.40 ($124,184.00 plus $12,418.40). After the second year, interest is again computed. It is $13,660.24 ($136,602.40 × 10 percent). It is compounded raising the principal to $150,262.64 ($136,602.40 plus $13,660.24).

The Present Value of Cash Flows Paid as an Annuity

Question: Does the application of present value change substantially if cash is paid each year rather than as a lump sum at the end of the term? What reporting is appropriate if an intangible asset is purchased by making a down payment today followed by a series of equal payments in the future?

To illustrate, assume a company acquires a copyright from an artist by paying $10,000 on January 1, Year One, and agreeing to pay an additional $10,000 at the beginning of each subsequent year until January 1, Year Five. The total cash amount is $50,000. As with the previous example, no separate interest is paid so that a present value computation is required. What is the historical cost to be reported for this intangible asset and what interest should be recorded on the liability over these future years?

 

Answer: Cash is conveyed over an extended period of time in this purchase. However, a reasonable rate of interest is not being explicitly paid to compensate for the delay in payments. Once again, accounting believes that interest exists within the cash amounts. A present value computation is necessary to pull out the appropriate amount of interest and leave just the cost of the newly acquired asset. As before, the present value of the payments is the cash paid after all future interest is mathematically removed. The idea behind the process has not changed. Here, though, cash is not conveyed as a single amount but rather as an annuityA series of equal payments made at equal time intervals.—an equal amount paid at equal time intervals. An annuity can be either of the following:

  • An ordinary annuityAn annuity with payments made at the end of each period; it is also referred to as an annuity in arrears. with payments made at the end of each period
  • An annuity dueAn annuity with payments made at the beginning of each period; it is also referred to as an annuity in advance. with payments starting immediately at the beginning of each period

The specific series of payments in this question is an annuity due pattern because the first $10,000 is conveyed immediately when the contract is signed. As before, the applicable present value factor to remove the interest can be determined by a calculatorThe mathematical formula to determine the present value of an annuity due of $1 per period is present value of an annuity due = [(1 – 1/[1 + i]n)/i] × (1 + i), where i is the appropriate interest rate and n is the number of payment periods.The mathematical formula to determine the present value of an ordinary annuity of $1 per period is present value of an ordinary annuity = (1 – 1/[1 + i]n)/i, where i is the appropriate interest rate and n is the number of payment periods. or computer spreadsheet.On an Excel spreadsheet, the present value of a $1 per year annuity due for five periods at a reasonable rate of 12 percent is computed by typing the following data into a cell: =PV(.12,5,1,,1). Therefore, the present value of seven annual payments of $25,000 made as annuity due with a reasonable interest rate of 9 percent would be found by entering =PV(.09,7,25000,,1)If this had been an ordinary annuity because the initial payment was delayed until the end of the first period, present value of that $1 per year ordinary annuity is =PV(.12,5,1,,0). The present value of seven annual payments of $25,000 made as an ordinary annuity with a reasonable interest rate of 9 percent would be found by entering =PV(.09,7,25000,,0) Tables are also available at the end of this book or through the following Internet link.

Present Value of an Annuity Due of $1 per Period

http://www.principlesofaccounting.com/ART/fv.pv.tables/pvforannuitydue.htm

Regardless of the approach applied, if a reasonable rate is assumed to be 12 percent per year, the present value of a $1 per year annuity due for five periods is 4.0374. Thus, the present value of paying $10,000 annually for five years beginning immediately is $10,000 times 4.0374 or $40,374. For annuities, the computation is constructed so that a single payment ($10,000) is multiplied rather than the total cash amount ($50,000).

Of the total cash to be paid, $40,374 (the present value) is the cost of the copyright with the remaining $9,626 ($50,000 total less $40,374) representing the interest expense over this period. The initial journal entry to record this acquisition is shown in Figure 11.7 “Acquisition of Intangible Asset—Present Value of an Annuity Due”. No interest is reported because no time has yet passed.

Figure 11.7 Acquisition of Intangible Asset—Present Value of an Annuity Due

At the end of the first year, amortization of the cost of the copyright must be recognized along with interest expense on the liability. Assuming a life of ten years and no residual value, annual amortization is $40,374 divided by ten years, or $4,037. Interest for the period is the $30,374 principal of the liability times the 12 percent reasonable rate, or $3,645 (rounded). Because no interest is explicitly paid in this contract, all of this interest is compounded (added to the liability). The year-end adjusting entries are shown in Figure 11.8 “Intangible Asset—Recognition of Interest and Amortization for Year One”.

Figure 11.8 Intangible Asset—Recognition of Interest and Amortization for Year One

The second scheduled payment is made on January 1, Year Two, and reduces the amount of the liability.

Figure 11.9 Second Payment for Copyright—Start of Year Two

At the end of Year Two, both amortization of the asset’s cost and interest expense on the liability must be recognized again to reflect the passage of another period. The amortization figure remains the same (assuming application of the straight-line method) but interest must be recomputed. The principal of the liability was $30,374 for the first year, but interest of $3,645 was then compounded at the end of that period followed by another $10,000 payment. As shown in Figure 11.10 “Computation of Liability Principal Throughout Year Two”, these changes result in a liability principal throughout Year Two of $24,019.

Figure 11.10 Computation of Liability Principal Throughout Year Two

Thus, during the second year, the principal amount of the liability is $24,019 and the interest, at the reasonable rate of 12 percent, is $2,882 (rounded).

Figure 11.11 Intangible Asset—Recognition of Interest and Amortization for Year Two

This pattern of entries will continue until the liability has been extinguished and the capitalized cost of the asset amortized to expense.

Key Takeaway

In making purchases, companies often delay making cash payments for years. If interest is calculated and paid in the interim, the purchase price and the interest are easy to differentiate and record. The accounting is straightforward. However, if no interest payments are specified, a present value computation is made to separate the amount paid for the asset from the interest. The resulting amount (the present value) is recognized initially for both the asset and liability. Present value can be determined using a table, a mathematical formula, or an Excel spreadsheet. Thereafter, interest is recognized each period and compounded (added to the principal of the liability) since it is not paid at the time. Future cash payments can be a single amount or an annuity (a stream of equal payments made at equal time intervals). Payments constitute an ordinary annuity if made at the end of each period or an annuity due if started immediately.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

 

Question: Goodwill is one of the most misunderstood balances on any set of financial statements. For example, at June 30, 2011, Procter & Gamble reported goodwill of nearly $58 billion. Many investors (even serious investors) probably are unsure of what to make of that number. How do you factor the reported balance for goodwill into your decision making?

Kevin Burns: I am not a big fan of goodwill. As a reported asset, it is way too subjective and frankly I am not sure that it provides credible information. How do you value something from an accounting standpoint that you cannot really measure or touch or feel? You cannot borrow against it. The goodwill balance is irrelevant for the kind of investing I do where I am more interested in asset values and what the real market values are for those assets. My feeling about goodwill is a bit like my feeling for financial footnotes. I prefer companies that can explain how they have value and make money without relying too much on either one.

11.6 End-of-Chapter Exercises

Questions

  1. Define “intangible asset” and give three common examples.
  2. For accounting purposes, at what amount are intangible assets typically reported?
  3. What are the six general types of intangibles that are reported as assets?
  4. In connection with intangible assets, what is the purpose of amortization?
  5. A company owns an intangible asset that is being amortized to expense over fifteen years. How was this fifteen-year period determined?
  6. The Ladorne Company owns a patent with a historical cost of $130,000 and a net book value of $82,000. The patent has become extremely valuable and is now worth $2.2 million. What does Ladorne report on its balance sheet for this intangible asset? Explain the reason for that method of accounting.
  7. The Bailor Company has a copyright with a cost of $200,000 and annual amortization of $40,000. In recording amortization, why might the company reduce the copyright’s cost directly rather than set up a separate accumulated amortization account?
  8. The Winston Corporation holds a patent with a cost of $2.1 million and a net book value of $1.5 million. Winston has to defend its right to this patent in court at a cost of $212,000. In what ways can this legal cost be reported?
  9. Large Corporation purchases all of the outstanding capital stock of Small Corporation. Large paid an especially large amount because Small had a certain attribute that was valued at over $3 million. Under what condition will Large be able to recognize this attribute as an identifiable intangible asset after the purchase has been finalized?
  10. Large Corporation purchases all of the outstanding capital stock of Small Corporation. Large paid an especially large amount because Small had a certain attribute that was valued at over $3 million. Assume that this attribute does not qualify for separate recognition as an identifiable intangible asset. What reporting will Large make of this $3 million on consolidated financial statements after the acquisition is finalized?
  11. A decision maker looks at the financial statements produced by the Rotolo Corporation for the current year. On the balance sheet, an account titled “goodwill” is reported with a balance of $13.8 million. What does the decision maker know from this information?
  12. Goodwill is recognized on a consolidated balance sheet on January 1, Year One. What happens to that asset balance over subsequent years?
  13. Giant Corporation acquires all of the outstanding capital stock of Little Corporation on January 1, Year One. As a result, goodwill of $15 million is reported. On a balance sheet produced 5 years later, will the goodwill balance still be reported and, if so, will $15 million be the figure that appears?
  14. Hammerstine Corporation pays $3 million for research and $5 million for development in connection with the creation of a new product that the company believes will generate over $19 million in revenue. How are the research and development costs reported under U.S. GAAP?
  15. How does U.S. GAAP differ in its method of reporting research and development costs from the rules established by IFRS?
  16. The Albright Corporation spends millions each year on research and development and, as a result, has been able to create a number of valuable patents and copyrights. Because of the handling required by U.S. GAAP, what can a decision maker say about a balance sheet reported by the Albright Corporation?
  17. What are the advantages of reporting research and development costs in the method required by U.S. GAAP?
  18. A company pays $2 million to acquire a patent. Under two different conditions, no determination of present value is required. What are those two conditions?
  19. The NortonRidge Corporation buys an intangible asset for $11 million to be paid in five years. No other payment is to be made. The present value of this cash payment is computed as $7.6 million using a reasonable interest rate. Mechanically, what does a present value computation accomplish?
  20. An intangible asset with a five-year useful life and no residual value is bought on January 1, Year One, for $4 million. However, the purchase is made with a future cash payment that has a present value of only $3 million based on a reasonable annual interest rate of 10 percent. What is the total amount of expense to be reported by the acquiring company in Year One?
  21. An intangible asset with a five-year useful life and no residual value is bought on January 1, Year One, for $4 million. However, the purchase is made with a future cash payment that has a present value of only $3 million based on a reasonable annual interest rate of 10 percent. What is the total amount of expense to be reported by the acquiring company in Year Two?
  22. A company has agreed to pay $6 million in the future and needs to determine the present value of that cash flow. What three pieces of information are needed to calculate present value?
  23. What is meant by the term “compounding”?
  24. What is the difference between an ordinary annuity and an annuity due?

True or False

  1. ____ On December 31, Year One, a company acquires a trademark and reports the intangible asset on its balance sheet at that date at $1.3 million. This figure represents the historical cost of this asset.
  2. ____ A company has a technology-related asset. It also has a marketing-related asset. These two assets cannot both be reported as intangible assets at the same time.
  3. ____ Amortization of intangibles is usually done over the asset’s legal life.
  4. ____ If an intangible asset is successfully defended from a legal challenge, the incurred legal costs are capitalized to the asset account.
  5. ____ Typically, intangible assets are shown on a company’s balance sheet at fair value.
  6. ____ One company acquires another. Subsequently, the acquiring company continues to report any intangible assets owned by the acquired company at the same historical cost basis that had been used by the acquired company.
  7. ____ A company has bought another company and is in the process of identifying the acquired intangible assets. To be reported as an intangible asset on a consolidated balance sheet, the parent company must be able to separate the item from the subsidiary and sell it.
  8. ____ A balance sheet reports goodwill as an intangible asset at $745,000. This figure indicates that the reporting company has an especially talented workforce.
  9. ____ A balance sheet reports goodwill as an intangible asset at $745,000. This figure indicates that the reporting company has given an extensive amount of money to charities.
  10. ____ Goodwill is an intangible asset that is usually written off to expense over forty years, although its actual life is likely to be much shorter than that.
  11. ____ After a company records goodwill, it will remain on the company’s balance sheet forever because it is not amortized.
  12. ____ A company must be able to connect goodwill with a specific intangible (such as the quality of a company’s workforce) before the asset can be recognized on a balance sheet.
  13. ____ Research and development costs that help a company to develop successful products are capitalized under U.S. GAAP.
  14. ____ Because of the handling of research and development costs required by U.S. GAAP, companies that spend significant amounts to develop new products will normally have exceptionally high amounts reported as assets on their balance sheets.
  15. ____ U.S. GAAP and IFRS handle research and development costs in the same manner.
  16. ____ A company agrees to pay $2 million for a patent in six years plus interest at an annual rate of 5 percent, which is considered a reasonable rate. A present value calculation must be carried out to determine the amount to be reported for the asset and the related liability.
  17. ____ A company buys a copyright for $400,000 on January 1, Year One. If four payments are to be made annually on each January 1, starting on January 1, Year One, the asset balance is determined by finding the present value of an annuity due.
  18. ____ On January 1, Year One, a company buys an intangible asset by agreeing to make a single payment of $300,000 in five years. Assume that, at a 10 percent annual interest rate which is viewed as reasonable, the present value is $170,000. On December 31, Year One, the liability is reported as $187,000.
  19. ____ On January 1, Year One, a company buys an intangible asset by agreeing to make a single payment of $500,000 in five years. Assume that, at a 10 percent annual interest rate which is viewed as reasonable, the present value is $310,000. Interest expense to be recognized in Year Two is $34,100.
  20. ____ On January 1, Year One, a company buys an intangible asset by agreeing to make a single payment of $700,000 in five years. Assume that, at a 10 percent annual interest rate which is viewed as reasonable, the present value is $400,000. The asset is expected to last for eight years and have no residual value. Amortization expense recognized on the asset for Year One is $50,000.

Multiple Choice

  1. A company spends $600,000 on research and $800,000 on development to earn a patent on a new invention. All of the legal costs to establish the patent amounted to $50,000. The company also had to spend an additional $90,000 to defend the patent (successfully) against a law suit. What is the capitalized cost of this patent?

    1. $50,000
    2. $90,000
    3. $140,000
    4. $1,540,000
  2. On January 1, Year One, a company acquires the rights to an intangible asset for $300,000 with no residual value. The intangible has a legal life of ten years but is only expected to help generate revenues for six years. The straight-line method is always used. What is the net book value of this intangible asset at the end of Year Two?

    1. Zero
    2. $200,000
    3. $240,000
    4. $300,000
  3. Which of the following intangible assets would not be subject to amortization?

    1. Goodwill
    2. Patent
    3. Copyright
    4. All intangible assets are subject to amortization
  4. The Birmingham Corporation buys a patent from an inventor on January 1, Year One, for $350,000. The company expects the patent to help generate revenues for ten years. It has no residual value, and the straight-line method is always used. On December 31, Year Two, the patent has a fair value of $500,000. What is reported for this asset on the company’s balance sheet on that date?

    1. $280,000
    2. $350,000
    3. $400,000
    4. $500,000
  5. Krypton Corporation offers Earth Company $800,000 for a patent held by Earth Company. The patent is currently recorded by Earth Company at $14,000, the legal cost required to register the patent. Krypton had appraisers examine the patent before making an offer to purchase it, and those experts determined that it was worth between $459,000 and $1,090,000. If the purchase falls through, at what amount should Earth Company now report the patent?

    1. $14,000
    2. $459,000
    3. $800,000
    4. $1,090,000
  6. Mitchell Inc. developed a product, spending $4,000,000 in research and $1,100,000 in development to do so. Mitchell applied for and received a patent for the product on January 1, Year One, spending $34,000 in legal and filing fees. The patent is valid for twenty years and is expected to generate revenue for that period of time. The patent has no expected residual value after that date. The straight-line method is always applied. What would be the net book value of the patent at the end of Year One?

    1. $32,300
    2. $34,000
    3. $4,832,000
    4. $5,134,000
  7. The Goodin Corporation purchases all of the outstanding stock of the Winslow Corporation for $62 million. In buying Winslow, Goodin acquired several items that might qualify to be reported as identifiable intangible assets. Which of the following criteria are applied to determine whether Goodin can report an intangible?

    1. Goodin must have obtained contractual or other legal rights or the item can be separated from Winslow and sold.
    2. The item must have a life of over one year and generate revenue that the parent company can assess.
    3. The item must have a tangible element to it or be legally valid in nature.
    4. The item must improve the operations of Goodin or have a value that can be objectively determined.
  8. A decision maker picks up a set of financial statements for the Barnes Corporation. On the balance sheet, the largest asset is titled “Goodwill.” Which of the following statements is most likely to be true about this company?

    1. The company has donated significant amounts of money to charities in the local area.
    2. The company has bought other companies and paid more for those companies than the fair value of their identifiable net assets.
    3. The company has a large workforce of well-trained employees.
    4. The company has a superior management team in place.
  9. On January 1, Year One, the Curry Corporation pays $7 million for all of the outstanding capital stock of a company that holds three assets and no liabilities. It has a building with a net book value of $2.3 million and a fair value of $2.8 million. It has equipment with a net book value of $1.1 and a fair value of $900,000. It holds several patents with no book value but a fair value of $1.3 million. Curry believes that this new subsidiary will be especially profitable for at least ten years. On a consolidated balance sheet as of December 31, Year One, what will Curry report as its goodwill balance?

    1. $1.3 million
    2. $1.8 million
    3. $2.0 million
    4. $3.6 million
  10. Kremlin Company pays $2,900,000 for all of the outstanding common stock of Reticular Corporation. Reticular has assets on its balance sheet with a net book value of $1,500,000 and a fair value of $2,500,000. Reticular had no liabilities at this time. What is goodwill in this purchase?

    1. $0
    2. $400,000
    3. $1,000,000
    4. $1,400,000
  11. Which of the following statements concerning research and development costs is not true?

    1. According to U.S. GAAP, research and development costs must be expensed as incurred.
    2. Current U.S. GAAP rules for reporting research and development costs violate the matching principle.
    3. International Financial Reporting Standards allow some development costs to be capitalized.
    4. U.S. GAAP reporting for research and development costs creates exceptionally large asset balances.
  12. The Barcelona Company is a technology company and spends an enormous amount on research and development. The company has been successful in the past on a very high percentage of these projects. In connection with financial reporting, which of the following statements is true?

    1. Company officials must evaluate each project each year to estimate the possibility of success.
    2. All research and development costs will be capitalized and then amortized to expense over a reasonable period of time.
    3. Any project where the possibility of success is more than 50 percent must be capitalized.
    4. The company’s total assets are probably worth more than shown on the balance sheet.
  13. Lincoln Company has an accounting policy for internal reporting purposes whereby the costs of any research and development projects that are over 70 percent likely to succeed are capitalized and then depreciated over a five-year period with a full year of depreciation in the year of capitalization. In the current year, $400,000 was spent on Project One, and it was 55 percent likely to succeed, $600,000 was spent on Project Two, and it was 65 percent likely to succeed, and $900,000 was spent on Project Three, and it was 75 percent likely to succeed. In converting the internal financial statements to external financial statements, by how much will net income for the current year have to be reduced?

    1. $180,000
    2. $380,000
    3. $720,000
    4. $900,000
  14. The El Paso Corporation buys a significant intangible asset for $900,000, an amount that will be paid in six years. If a reasonable annual interest rate is 5 percent, what is the capitalized cost of the asset?

    1. $522,743
    2. $671,594
    3. $754,090
    4. $900,000
  15. The Vaska Company buys a patent on January 1, Year One, and agrees to pay $100,000 per year for the next five years. The first payment is made immediately, and the payments are made on each January 1 thereafter. If a reasonable annual interest rate is 8 percent, what is the recorded value of the patent?

    1. $378,425
    2. $431,213
    3. $468,950
    4. $500,000
  16. On January 1, Year One, the Anderson Corporation buys a copyright and agrees to make a single payment of $700,000 in exactly four years. A reasonable annual interest rate is viewed as 10 percent, and a present value of $478,107 was determined. What amount of interest expense should Anderson recognize for Year One?

    1. Zero
    2. $47,811
    3. $70,000
    4. Cannot be determined from the information provided.
  17. On January 1, Year One, the Maroni Corporation buys an intangible asset and agrees to make a single payment of $800,000 in exactly six years. A reasonable annual interest rate is viewed as 10 percent, and a present value of $451,580 was determined. What amount of interest expense should Maroni recognize for Year Two?

    1. Zero
    2. $45,158
    3. $49,674
    4. $80,000
  18. The Heinline Company buys a patent on January 1, Year One, and agrees to pay exactly $100,000 per year for the next eight years (or $800,000 in total). The first payment is made immediately, and the payments are made on each January 1 thereafter. A reasonable annual interest rate is 10 percent, which gives an assumed present value of $586,840. What amount of interest expense should Heinline recognize for Year Two?

    1. Zero
    2. $43,552
    3. $58,684
    4. $60,000

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own a chain of ice cream shops located throughout Florida. One day, while reading a play by Shakespeare, your roommate poses this question: “My parents recently bought a new shop in Tallahassee. They bought it from an elderly couple who wanted to retire. It is in a great location and already has a huge number of regular customers. However, I don’t understand why they paid so much. The building and land were worth $1 million, and the equipment and ice cream on hand couldn’t have been worth more than $25,000. So, I expected them to pay around $1,025,000. But they paid $1.5 million. Why in the world did they pay so much? How are they ever going to report that shop in the future since they clearly overpaid?” How would you respond?

  2. Your uncle and two friends started a small office supply store several years ago. The company has expanded and now has several large locations. Your uncle knows that you are taking a financial accounting class and asks you the following question: “In the office supply business, the North Lakeside Company is the best known name in the world. They manufacture great products, and everyone has heard of their high quality. We started selling their merchandise recently. We wanted to let people know of this relationship. We want to put the North Lakeside logo on each of our stores so that our customers would associate us with that same level of quality. It is good for our business, and it will bring us more customers who will buy more goods. We contacted North Lakeside about using their logo. They told us they would give us that right for $400,000. Well, we don’t have that type of cash available at this time just for a logo. We tried to negotiate with them, and they said they still wanted exactly $400,000, but we could wait for four years before making the payment. By that time, the logo should have produced a lot of extra profits for us. We’ve certainly never done something like this before. When we sign the contract, how do we report this transaction?” How would you respond?

Problems

  1. At the beginning of Year One, Jaguar Corporation purchased a license from Angel Corporation that gives Jaguar the legal right to use a process Angel developed. The purchase price of the license was $1,500,000, including legal fees. According to the agreement, Jaguar will be able to use the process for five years.

    1. Record Jaguar’s purchase of the license.
    2. Record amortization of the license at the end of Year One assuming the straight-line method is used and there is no expected residual value.
    3. What is the net book value of the license reported on Jaguar’s balance sheet at the end of Year Three?
  2. Yolanda Company created a product for which it was able to obtain a patent. Yolanda sold this patent to Christiana Inc. for $4 million at the beginning of Year One. Christiana paid an additional $200,000 in legal fees to properly record the patent. On that date, Christiana determined that the patent had a remaining legal life of ten years but a useful life of only seven years. The straight-line method is to be applied with no expected residual value.

    1. Record Christiana’s purchase of the patent.
    2. Record amortization of the patent at the end of Year One and Year Two.
    3. What is the book value of the patent reported on Christiana’s balance sheet at the end of Year Three?
    4. During Year Four, Christiana is sued by Bushnell Corporation. Bushnell claims that it has a patent on a product very similar to the one held by Christiana and that Bushnell’s patent was registered first. Christiana spends $600,000 during Year Four and successfully defends the patent. What entry is made for these expenditures?
    5. Use the same facts as in 2.d. except assume that Christiana is not able to successfully defend its right to this patent. What journal entry is made?
  3. As of January 1, Year One, Company Z has no liabilities and only two assets: a donut maker with a net book value of $300,000 (and a fair value of $360,000) and a cookie machine with a net book value of $400,000 (and a fair value of $440,000). Each of these assets has a remaining useful life of ten years and no expected residual value. Company A offers $1 million to acquire all of the ownership of Company Z. The owners of Company Z hold out and manage to get $1.2 million in cash.

    1. Make the journal entry to be recorded by Company A for this acquisition.
    2. What depreciation/amortization expense will Company A recognize in connection with these acquired assets at the end of Year One?
    3. What is the appropriate handling of any goodwill resulting from this transaction?
  4. On January 1, Year One, a pharmaceutical company starts work on creating three new medicines that could lead to valuable products. The company will spend millions on each project and would not undertake this endeavor if it did not believe that it has a reasonable chance of recovering its investment. Historically for this company, one out of every three new projects actually became a successful product on the market. If that happens, the company expects to generate over $10 million in revenue at a minimum. By the end of Year One, the company spent exactly $1 million in research and development for each of three projects. Based on a careful evaluation, company officials believe the first project has a 30 percent chance of success, the second project has a 60 percent chance of success, and the third project has a 90 percent chance of success.

    1. Assume U.S. GAAP does not have an official standard in this area of accounting. Provide as many viable methods as possible to record the $3 million cost that has been incurred to