Distinguish between gross profit as a percentage of cost and gross profit as a percentage of sales price.

Distinguish between gross profit as a percentage of cost and gross profit as a percentage of the sales price.

Gross profit as a percentage of sales indicates that the markup is based on selling price rather than cost; for this reason, the gross profit as a percentage of the selling price will always be lower than if based on cost.

What are the major uses of the gross profit method?

What are the major uses of the gross profit method?

The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted.

Under what circumstances is relative sales value an appropriate basis for determining the price assigned to inventory?

Under what circumstances is relative sales value an appropriate basis for determining the price assigned to inventory?

Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory.

What approaches may be employed in applying the LCNRV procedure? Which approach is normally used and why?

What approaches may be employed in applying the LCNRV procedure? Which approach is normally used and why?

The lower-of-cost-and-net realizable value rule may be applied directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements in some countries require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation on the statement of financial position.

Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inventories?

Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inventories?

The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required; however, when the utility of the goods included in the inventory is less than their cost, this loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-and-net realizable value rule arose from the accounting convention of providing for all losses and anticipating no profits.)

In accordance with the foregoing reasoning, the rule of "cost and net realizable value, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable.

The arguments against the use of the lower-of-cost-and-net realizable value method of valuing inventories include the following:

(a) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over net realizable value) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization, a drop in net realizable value below original cost is no more a sustained loss than a rise above cost is a realized gain.
(b) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-downs is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer.
(c) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of the price increases.
(d) The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost in one year and at net realizable value in the next year.
(e) The lower-of-cost-and-net realizable value method values the inventory in the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize.

Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?

Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes?

The unit LIFO inventory costing method is applied to each type of item in an inventory. Any type of item removed from the inventory base (e.g., magnets) and replaced by another type (e.g., coils) will cause the old cost (magnets) to be removed from the base and to be replaced by the more current cost of the other item (coils).

The dollar-value LIFO costing method treats the inventory base as being composed of a base of cost in dollars rather than of units. Therefore, a change in the composition of the inventory (fewer magnets and more coils) will not change the cost of inventory base so long as the amount of the inventory stated in base-year dollars does not change.

(a) LIFO layer.
(b) LIFO reserve.
(c) LIFO effect.
(a)
LIFO layer—a LIFO layer (increment) is formed when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices.

(b)
LIFO reserve—the difference between the inventory method used for internal purposes and LIFO.

(c)
LIFO effect—the change in the LIFO reserve (Allowance to Reduce Inventory to LIFO) from one period to the next.

What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation?

What advantage does the dollar-value method have over the specific goods approach of LIFO inventory valuation?

The principal advantage is that it requires less record-keeping. It is not necessary to keep records or make calculations of opening and closing quantities of individual items. Also, the use of a base inventory amount gives greater flexibility in the makeup of the base and eliminates many detailed calculations.

What is the dollar-value method of LIFO inventory valuation?

What is the dollar-value method of LIFO inventory valuation?

The dollar-value method uses dollars instead of units to measure increments, or reductions in a LIFO inventory. After converting the closing inventory to the same price level as the opening inventory, the increases in inventories, priced at base-year costs, is converted to the current price level and added to the opening inventory. Any decrease is subtracted at base-year costs to determine the ending inventory.

FIFO, average-cost, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation.

FIFO, average-cost, and LIFO methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation.

The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which they are incurred. As a result, the inventories are stated at the latest costs. Where the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported income is not fully available since a part of it must be used to replace inventory at higher cost.

The results achieved by the average-cost method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the average-cost method has the advantage that the goods need not be individually identified; therefore accounting is not so costly and the method can be applied to fungible goods. The average-cost method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories.

If it is assumed that actual cost is the appropriate method of valuing inventories, last-in, first-out is not theoretically correct. In general, LIFO is directly adverse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues.

During periods of sharp price movements, LIFO has a stabilizing effect upon reported income figures because it eliminates paper income and losses on inventory and smoothies the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figures can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction

Distinguish between product costs and period costs as they relate to inventory.

Distinguish between product costs and period costs as they relate to inventory.

By their nature, product costs "attach" to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labour and other production costs incurred in processing the goods up to the time of sale.

Period costs are not considered to be directly related to the acquisition or production of goods and therefore are not considered to be a part of inventories.

Conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. While selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory, in most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary.

Interest costs are considered a cost of financing and are generally expensed as incurred when related to getting inventories ready for sale.

Define "cost" as applied to the valuation of inventories.

Define "cost" as applied to the valuation of inventories.

Cost, which has been defined generally as the price paid or consideration is given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. Freight charges applicable to the product are considered a cost of the goods.

Where, if at all, should the following items be classified on a balance sheet?

Where, if at all, should the following items be classified on a balance sheet?

(a) Goods out on approval to customers.
(b) Goods in transit that were recently purchased f.o.b. destination.
(c) Land held by a realty firm for sale.
(d) Raw materials.
(e) Goods received on consignment.
(f) Manufacturing supplies.
(a) Inventory.

(b)
Not shown, possibly in a note to the financial statements if material.

(c) Inventory.

(d) Inventory, separately disclosed as raw materials.

(e)
Not shown, possibly a note to the financial statements.

(f) Inventory or manufacturing supplies.

What is a repurchase agreement (product financing) arrangement? How should a product repurchase agreement be reported in the financial statements?

What is a repurchase agreement (product financing) arrangement? How should a product repurchase agreement be reported in the financial statements?

Repurchase agreements (product financing arrangements) are essentially off-balance-sheet financing devices. These arrangements make it appear that a company has sold its inventory or never taken title to it so they can keep loans off their balance sheets. A repurchase agreements arrangement should not be recorded as a sale. Rather, the inventory and related liability should be reported on the balance sheet.

What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why?

In a perpetual inventory system, data are available at any time on the quantity and dollar amount of each item of material or type of merchandise on hand. A physical inventory is a physical count of inventory on hand at a point in time. In a periodic system, the inventory is periodically counted (at least once a year) but that up-to-date records are not necessarily maintained. Discrepancies often occur between the physical count and the perpetual records because of clerical errors, theft, waste, misplacement of goods, etc

In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?

In what ways are the inventory accounts of a retailing company different from those of a manufacturing company?

In a retailing concern, inventory normally consists of only one category that is the product awaiting resale. In a manufacturing company, inventories consist of raw materials, work in process, and finished goods. Sometimes a manufacturing or factory supplies inventory account is also included.

What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

What is the fair value option? Where do companies that elect the fair value option report unrealized holding gains and losses?

The fair value option gives companies the option of using fair value as the measurement basis for financial instruments. The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. If companies choose the fair value option, the receivables are recorded at fair value, with unrealized gains or losses reported as part of net income.

Indicate three reasons why a company might sell its receivables to another company.
A company might sell receivables because money is tight and access to normal credit is not available or prohibitively expensive. Also, a company may have to sell its receivables, instead of borrowing, to avoid violating existing lending arrangements. In addition, billing and collection of receivables are often time-consuming and costly.

Indicate how the percentage-of-receivables method, based on an ageing schedule, accomplishes the objectives of the allowance method of accounting for bad debts. What other methods, besides an ageing analysis, can be used for estimating uncollectible accounts?

Indicate how the percentage-of-receivables method, based on an ageing schedule, accomplishes the objectives of the allowance method of accounting for bad debts. What other methods, besides an ageing analysis, can be used for estimating uncollectible accounts?

The percentage of receivables method based on an aging schedule calculates each year's debit to the expense account and credit to the allowance account by evaluating the collectability of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is a common procedure. For each of the age categories established in the analysis, average percentage rates may be developed on the basis of past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. On the basis of the foregoing analysis the balance in the valuation account is then adjusted to the amount estimated to be uncollectible.

This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at their estimated net realizable value in the balance sheet. From the stand-point of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales. The accuracy of both the charge to bad debt expense and the reported value of receiv-ables depends on the current estimate of uncollectible accounts. The accuracy of the expense charge, however, is additionally dependent upon the timing of actual write-offs.

Other methods that companies may use employ estimates based on historical loss ratios for customers with different credit ratings as a basis for estimating uncollectible accounts. Or a company may utilize a probability-weighted discounted cash flow model (as illustrated in Chapter 6) to estimate expected credit losses.

What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

What is the theoretical justification of the allowance method as contrasted with the direct write-off method of accounting for bad debts?

The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash.

Second, accounts receivable on the balance sheet should be stated at their estimated net realizable value. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement.

What are the basic problems that occur in the valuation of accounts receivable?

What are the basic problems that occur in the valuation of accounts receivable?

The basic problems that relate to the valuation of receivables are (1) the determination of the face value of the receivable, (2) the probability of future collection of the receivable, and (3) the length of time the receivable will be outstanding. The determination of the face value of the receivable is a function of the trade discount, cash discount, and certain allowance accounts such as the Allowance for Sales Returns and Allowances.

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

Two methods of recording accounts receivable are:

1. Record receivables and sales gross.
2. Record receivables and sales net.

The net method is desirable from a theoretical standpoint because it values the receivable at its net realizable value. In addition, recording the sales at net provides a better assessment of the revenue that was recognized from the sale of the product. If the purchasing company fails to take the discount, then the company should reflect this amount as income. The gross method for receivables and sales is used in practice normally because it is expedient and its use does not generally have any significant effect on the presentation of the financial statements.

What are the reasons that a company gives trade discounts? Why are trade discounts not recorded in accounts like cash discounts?

What are the reasons that a company gives trade discounts? Why are trade discounts not recorded in accounts like cash discounts?

The seller normally uses trade discounts to avoid frequent changes in its catalogs, to quote different prices for different quantities purchased, and to hide the true invoice price from competitors. Trade discounts are not recorded in the accounts because the price finally quoted is generally an accurate statement of the fair market value of the product on that date. In addition, no subsequent changes can occur to affect this value from an accounting standpoint. With a cash discount, the buyer receives a choice and events subsequent to the original transaction dictate that additional entries may be needed.

What may be included under the heading of "cash"?

What may be included under the heading of "cash"?

Cash normally consists of coins and currency on hand, bank deposits, and various kinds of orders for cash such as bank checks, money orders, travelers' checks, demand bills of exchange, bank drafts, and cashiers' checks. Balances on deposit in banks which are subject to immediate withdrawal are properly included in cash. Money market funds that provide checking account privileges may be classified as cash. There is some question as to whether deposits not subject to immediate withdrawal are properly included in cash or whether they should be set out separately. Savings accounts, certificates of deposit, and time deposits fall in this latter category. Unless restrictions on these kinds of deposits are such that they cannot be converted (withdrawn) within one year or the operating cycle of the entity, whichever is longer, they are properly classified as current assets. At the same time, they may well be presented separately from other cash and the restrictions as to convertibility reported.

State the generally accepted accounting principle applicable to balance sheet valuation of each of the following assets.

State the generally accepted accounting principle applicable to balance sheet valuation of each of the following assets.

(a) Trade accounts receivable.
(b) Land.
(c) Inventories.
(d) Trading securities (common stock of other companies).
(e) Prepaid expenses.
(a)
Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts.

(b)
Land is generally stated in the balance sheet at cost.

(c)
Inventories are generally stated at the lower of cost or market.

(d)
Trading securities (consisting of common stock of other companies) are stated at fair value.

(e)
Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods

Where should the following items be shown on the balance sheet, if shown at all?

Where should the following items be shown on the balance sheet, if shown at all?

(a) Allowance for doubtful accounts.
(b) Merchandise held on consignment.
(c) Advances received on sales contract.
(d) Cash surrender value of life insurance.
(e) Land.
(f) Merchandise out on consignment.
(g) Franchises.
(h) Accumulated depreciation of equipment.
(i) Materials in transit—purchased f.o.b. destination.
(a)
Allowance for doubtful accounts should be deducted from accounts receivable in current assets.

(b)
Merchandise held on consignment should not appear on the consignee's balance sheet except possibly as a note to the financial statements.

(c)
Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet.

(d)
Cash surrender value of life insurance should be shown as a long-term investment.

(e)
Land should be reported in property, plant, and equipment unless held for investment.

(f)
Merchandise out on consignment should be shown among current assets under the heading of inventory.

(g)
Franchises should be itemized in a section for intangible assets.

(h)
Accumulated depreciation of plant and equipment should be deducted from the equipment account.

(i)
Materials in transit should not be shown on the balance sheet of the buyer, if purchased f.o.b. destination.

In what section of the balance sheet should the following items appear, and what balance sheet terminology would you use?

In what section of the balance sheet should the following items appear, and what balance sheet terminology would you use?

(a) Treasury stock (recorded at cost).
(b) Checking account at bank.
(c) Land (held as an investment).
(d) Sinking fund.
(e) Unamortized premium on bonds payable.
(f) Copyrights.
(g) Pension fund assets.
(h) Premium on capital stock.
(i) Long-term investments (pledged against bank loans payable).
(a)
Stockholders' Equity. "Treasury stock (at cost)."
Note: This is a reduction of total stockholders' equity (reported as contra-equity).

(b)
Current Assets. Included in "Cash."

(c)
Long-Term Investments. "Land held as an investment."

(d)
Long-Term Investments. "Sinking fund."

(e)
Long-term debt (adjunct account to bonds payable). "Unamortized premium on bonds payable."

(f)
Intangible Assets. "Copyrights."

(g)
Investments. "Employees' pension fund," with subcaptions of "Cash" and "Securities" if desired. (Assumes that the company still owns these assets.)

(h)
Stockholders' Equity. "Additional paid-in capital."

(i)
Investments. Nature of investments should be given together with parenthetical information as follows: "pledged to secure loans payable to banks."

Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?

Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?

Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the "intellectual capital" of its workforce (the ability of the companies' employees to come up with new ideas and products in the fast-changing technology industry), and the value of the company reputation or name brand (e.g., the "Intel Inside" logo). In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these "assets" (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework.

What are the major limitations of the balance sheet as a source of information?

What are the major limitations of the balance sheet as a source of information?

The major limitations of the balance sheet are:

(a) The values stated are generally historical and not at fair value.
(b) Estimates have to be used in many instances, such as in the determination of collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets.
(c) Many items, even though they have financial value to the business, presently are not recorded. One example is the value of a company's human resources.

What is meant by liquidity?

What is meant by liquidity?

Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until liability has to be paid.

Discuss at least two situations in which estimates could affect the usefulness of the information in the balance sheet.

Discuss at least two situations in which estimates could affect the usefulness of the information in the balance sheet.

Some situations in which estimates affect amounts reported in the balance sheet include:

(a) allowance for doubtful accounts.
(b) depreciable lives and estimated salvage values for plant and equipment.
(c) warranty returns.
(d) determining the amount of revenues that should be recorded as unearned.

When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the faithful representation of the measures, either because of bias or lack of verifiability.

How does information from the balance sheet help users of the financial statements?

How does information from the balance sheet help users of the financial statements?

The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners' equity in net enterprise resources. That information not only complements information about the components of income but also contributes to financial reporting by providing a basis for

(1) computing rates of return,
(2) evaluating the capital structure of the enterprise, and
(3) assessing the liquidity and financial flexibility of the enterprise.

What are some forms of off-balance-sheet financing?

What are some forms of off-balance-sheet financing?

Forms of off-balance-sheet financing include (1) investments in non-consolidated subsidiaries for which the parent is liable for the subsidiary debt; (2) use of special purpose entities (SPEs), which are used to borrow money for special projects (resulting in take-or-pay contracts); (3) operating leases, which when structured carefully give the company the benefits of ownership without reporting the liability for the lease payments.

What is off-balance-sheet financing? Why might a company be interested in using off-balance-sheet financing?

What is off-balance-sheet financing? Why might a company be interested in using off-balance-sheet financing?

Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Reasons for off-balance sheet financing are:

(1) Many believe removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost.
(2) Loan covenants are less likely to be violated.
(3) The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets.

What is the fair value option? Briefly describe the controversy of applying the fair value option to financial liabilities.

What is the fair value option? Briefly describe the controversy of applying the fair value option to financial liabilities.

A fair value option is an accounting option where the company can elect to record fair values in their accounts for most financial assets and liabilities, including bonds and notes payable.

With bonds at fair value, we assume that the decline in value of the bonds is due to an interest rate increase. If not related to changes in credit risks, these gains and losses are recorded in income. In other situations, the decline may occur because the issuer becomes more likely to default on the bonds. That is, if the creditworthiness of the issuer declines, the value of its debt also declines. If its creditworthiness declines, it's bond investors are receiving a lower rate relative to investors with similar-risk investments. Thus, changes in the fair value of bonds payable for a decline in creditworthiness are included as part of other comprehensive income.

What is done to record properly a transaction involving the issuance of a non-interest-bearing long-term note in exchange for property?

What is done to record properly a transaction involving the issuance of a non-interest-bearing long-term note in exchange for a property?

The entire arrangement must be evaluated and an appropriate interest rate imputed. This is done by (1) determining the fair value of the property, goods, or services exchanged or (2) determining the fair value of the note, whichever is more clearly determinable.

Why would a company wish to reduce its bond indebtedness before its bonds reach maturity?

Why would a company wish to reduce its bond indebtedness before its bonds reach maturity?

Indicate how this can be done and the correct accounting treatment for such a transaction.
It is sometimes desirable to reduce bond indebtedness in order to take advantage of lower prevailing interest rates. Also, the company may not want to make a very large cash outlay all at once when the bonds mature.

Bond indebtedness may be reduced by either issuing bonds callable after a certain date and then calling some or all of them, or by purchasing bonds on the open market and then retiring them.

When a portion of bonds outstanding is going to be retired, it is necessary for the accountant to make sure any corresponding discount or premium is properly amortized. When the bonds are extinguished, any gain or loss should be reported in income.

What is the "call" feature of a bond issue? How does the call feature affect the amortization of bond premium or discount?

What is the "call" feature of a bond issue? How does the call feature affect the amortization of bond premium or discount?

The call feature of a bond issue grants the issuer the privilege of purchasing, after a certain date at a stated price, outstanding bonds for the purpose of reducing indebtedness or taking advantage of lower interest rates. The call feature does not affect the amortization of bond discount or premium; because early redemption is not a certainty, the life of the bonds should be used for amortization purposes.

Will the amortization of Discount on Bonds Payable increase or decrease Bond Interest Expense?

Will the amortization of Discount on Bonds Payable increase or decrease Bond Interest Expense?

Increase

Briggs and Stratton recently issued debt with issue costs of $5.1 million. How should the costs of issuing these bonds be accounted for and classified in the financial statements?

Briggs and Stratton recently issued debt with issue costs of $5.1 million. How should the costs of issuing these bonds be accounted for and classified in the financial statements?

Bond issuance costs should be recorded as a reduction to the issue amount and then amortized into expense over the life of the bond. A deferred charge account is set up for Unamortized Bond Issue Costs and amortized over the life of the issue, separately from but in a manner similar to that used for a discount on bonds.

Zopf Company sells its bonds at a premium and applies the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds?

Zopf Company sells its bonds at a premium and applies the effective-interest method in amortizing the premium. Will the annual interest expense increase or decrease over the life of the bonds?

Decrease

How should a discount on bonds payable be reported on the financial statements? The premium on bonds payable?

How should a discount on bonds payable be reported on the financial statements? The premium on bonds payable?

Discount (premium) on bonds payable should be reported in the balance sheet as a direct deduction from (addition to) the face amount of the bond. Both are liability valuation accounts.

Under what conditions of bond issuance do a discount on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?

Under what conditions of bond issuance do a discount on bonds payable arise? Under what conditions of bond issuance does a premium on bonds payable arise?

A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can alter the effective rate of interest. A premium on bonds payable results from the opposite conditions. That is, when investors are satisfied with a rate of interest lower than the rate stated on the bonds, they are willing to pay more than the face value of the bonds in order to acquire them, thus reducing their effective rate of interest below the stated rate.

Distinguish between the following values relative to bonds payable:

Distinguish between the following values relative to bonds payable:

(a) Maturity value.
(b) Face value.
(c) Market (fair) value.
(d) Par value.


(a) Maturity value―the face value of the bonds; the amount which is payable upon maturity.

(b) Face value―synonymous with par value and maturity value.

(c) Market (fair) value―the amount realizable upon sale.

(d) Par value―synonymous with maturity and face value.

Distinguish between the following interest rates for bonds payable:

Distinguish between the following interest rates for bonds payable:

(a) Yield rate.
(b) Nominal rate.
(c) Stated rate.
(d) Market rate.
(e) Effective rate.


(a) Yield rate―the rate of interest actually earned by the bondholders; it is synonymous with the effective and market rates.

(b) Nominal rate―the rate set by the party issuing the bonds and expressed as a percentage of the par value; it is synonymous with the stated rate.

(c) Stated rate―synonymous with the nominal rate.

(d) Market rate―synonymous with yield rate and effective rate.

(e) Effective rate―synonymous with the market rate and yield rate.

Melissa Etheridge Inc. had a manufacturing plant in Sudan, which was destroyed in the civil war. It is not certain who will compensate Etheridge for this destruction, but Etheridge has been assured by governmental officials that it will receive a definite amount for this plant. The amount of the compensation will be less than the fair value of the plant, but more than its book value. How should the contingency be reported in the financial statements of Etheridge Inc.?

Melissa Etheridge Inc. had a manufacturing plant in Sudan, which was destroyed in the civil war. It is not certain who will compensate Etheridge for this destruction, but Etheridge has been assured by governmental officials that it will receive a definite amount for this plant. The amount of the compensation will be less than the fair value of the plant, but more than its book value. How should the contingency be reported in the financial statements of Etheridge Inc.?

This is a gain contingency because the amount to be received will be in excess of the book value of the plant. Gain contingencies are not recorded and are disclosed only when the probabilities are high that a gain contingency will become reality.

On October 1, 2017, Alan Jackson Chemical was identified as a potentially responsible party by the Environmental Protection Agency. Jackson's management along with its counsel have concluded that it is probable that Jackson will be responsible for damages, and a reasonable estimate of these damages is $5,000,000. Jackson's insurance policy of $9,000,000 has a deductible clause of $500,000. How should Alan Jackson Chemical report this information in its financial statements at December 31, 2017?

On October 1, 2017, Alan Jackson Chemical was identified as a potentially responsible party by the Environmental Protection Agency. Jackson's management along with its counsel have concluded that it is probable that Jackson will be responsible for damages, and a reasonable estimate of these damages is $5,000,000. Jackson's insurance policy of $9,000,000 has a deductible clause of $500,000. How should Alan Jackson Chemical report this information in its financial statements at December 31, 2017?

The loss should be accrued for $5,000,000. The potential insurance recovery is a gain contingency—it is not recorded until received.

During 2017, Salt-n-Pepa Inc. became involved in a tax dispute with the IRS. Salt-n-Pepa's attorneys have indicated that they believe it is probable that Salt-n-Pepa will lose this dispute. They also believe that Salt-n-Pepa will have to pay the IRS between $900,000 and $1,400,000. After the 2017 financial statements were issued, the case was settled with the IRS for $1,200,000. What amount, if any, should be reported as a liability for this contingency as of December 31, 2017?

During 2017, Salt-n-Pepa Inc. became involved in a tax dispute with the IRS. Salt-n-Pepa's attorneys have indicated that they believe it is probable that Salt-n-Pepa will lose this dispute. They also believe that Salt-n-Pepa will have to pay the IRS between $900,000 and $1,400,000. After the 2017 financial statements were issued, the case was settled with the IRS for $1,200,000. What amount, if any, should be reported as a liability for this contingency as of December 31, 2017?

The FASB requires that, when some amount within the range of expected loss appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed. In this case, therefore, Salt-n-Pepa Inc. would report a liability of $900,000 at December 31, 2017.

When should liabilities for each of the following items be recorded on the books of an ordinary business corporation?

When should liabilities for each of the following items be recorded on the books of an ordinary business corporation?

(a) Acquisition of goods by purchase on credit.
(b) Officers' salaries.
(c) Special bonus to employees.
(d) Dividends.
(e) Purchase Commitments.

(a) Liability for goods purchased on credit should be recorded when control passes to the purchaser. If the terms of purchase are f.o.b. destination, title passes when the goods purchased arrive; if f.o.b. shipping point, title passes when the shipment is made by the vendor.

(b) Officers' salaries should be recorded when they become due at the end of a pay period. Accrual of unpaid amounts should be recorded in preparing financial statements dated other than at the end of a pay period.

(c) A special bonus to employees should be recorded when approved by the board of directors or person having authority to approve if the bonus is for a period of time and that period has ended at the date of approval. If the period for which the bonus is applicable has not ended but only a part of it has expired, it would be appropriate to accrue a pro rata portion of the bonus at the time of approval and make additional accruals of pro rata amounts at the end of each pay period.

(d) Dividends should be recorded when they have been declared by the board of directors.

(e) Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that have not been shipped by the seller. Ordinary orders, for which the prices are determined at the time of shipment and subject to cancellation by the buyer or seller, do not represent either an asset or a liability to the buyer and need not be reflected in the books or in the financial statements. However, an accrued loss on purchase commitments which results from formal purchase contracts for which a firm price is in excess of the market price at the date of the balance sheet would be shown in the liability section of the balance sheet.

When must a company recognize an asset retirement obligation?

When must a company recognize an asset retirement obligation?

An asset retirement obligation must be recognized when a company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount can be reasonably estimated.

Explain the accounting for a service-type warranty.

Explain the accounting for a service-type warranty.

Companies record a service-type warranty as a separate performance obligation. For example, in the case of the television, the seller recognizes the sale of the television with the assurance-type warranty separately from the sale of the service-type warranty. The sale of the service-type warranty is usually recorded in an Unearned Warranty Revenue account. Companies then recognize revenue on a straight-line basis over the period the service-type warranty is in effect. Companies only defer and amortize costs that vary with and are directly related to the sale of the contracts (mainly commissions). Companies expense employees' salaries and wages, advertising, and general and administrative expenses because these costs occur even if the company did not sell the service-type warranty.

Explain the accounting for an assurance-type warranty.

Explain the accounting for an assurance-type warranty.

Companies do not record a separate performance obligation for assurance-type warranties. This type of warranty is nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed (in other words, at the point of sale). In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale due to the correction of defects or deficiencies required under the warranty provisions.

Distinguish between a determinable current liability and a contingent liability. Give two examples of each type.

Distinguish between a determinable current liability and a contingent liability. Give two examples of each type.

A determinable current liability is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation.

A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. It is a liability dependent upon a "loss contingency."

Current liabilities—accounts payable, notes payable, current maturities of long-term debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and accrued expenses.

Contingent liabilities—obligations related to product warranties and product defects, premiums offered to customers, certain pending or threatened litigation, certain actual and possible claims and assessments, and certain guarantees of indebtedness of others.

Under what conditions should a contingent liability be recorded?

Under what conditions should a contingent liability be recorded?

A contingent liability should be recorded and a charge accrued to expense only if:

(a) the information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and

(b) the amount of the loss can be reasonably estimated.

Define (a) a contingency and (b) a contingent liability.

Define (a) a contingency and (b) a contingent liability.

(a) A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.

(b) A contingent liability is a liability incurred as a result of a loss contingency.

How does unearned revenue arise? Why can it be classified properly as a current liability? Give several examples of business activities that result in unearned revenues.

How does unearned revenue arise? Why can it be classified properly as a current liability? Give several examples of business activities that result in unearned revenues.

Unearned revenue arises when a company receives cash or other assets as payment from a customer before conveying (or even producing) the goods or performing the services which it has committed to the customer.

Unearned revenue is assumed to represent the obligation to the customer to refund the assets received in the case of nonperformance or to perform according to the agreement and thus earn the unrestricted right to the assets received. While there may be an element of unrealized profit included among the liabilities when unearned revenues are classified as such, it is ignored on the grounds that the amount of unrealized profit is uncertain and usually not material relative to the total obligation.

Unearned revenues arise from the following activities:

(1) The sale by a transportation company of tickets or tokens that may be exchanged or used to pay for future fares.
(2) The sale by a restaurant of meal tickets that may be exchanged or used to pay for future meals.
(3) The sale of gift certificates by a retail store.
(4) The sale of season tickets to sports or entertainment events.
(5) The sale of subscriptions to magazines.

What is the nature of a "discount" on notes payable?

What is the nature of a "discount" on notes payable?

A discount on notes payable represents the difference between the present value and the face value of the note, the face value being greater in amount than the discounted amount. It should be treated as an offset (contra) to the face value of the note and amortized to interest expense over the life of the note. The discount represents interest expense chargeable to future periods.

How is the present value related to the concept of a liability?

How is the present value related to the concept of a liability?

Payables and receivables generally involve an interesting element. Recognition of the interest element (the cost of money as a factor of time and risk) results in valuing future payments at their current value. The present value of liability represents the debt exclusive of the interest factor.

How are current liabilities related by definition to current assets? How are current liabilities related to a company's operating cycle?

How are current liabilities related by definition to current assets? How are current liabilities related to a company's operating cycle?

Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities.

Because current liabilities are by definition tied to current assets and current assets by definition are tied to the operating cycle, liabilities are related to the operating cycle.

Distinguish between a current liability and a long-term debt.

Distinguish between a current liability and a long-term debt.

Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities. Long-term debt consists of all liabilities not properly classified as current liabilities.

Megan Hoffman invests in a "jumbo" $200,000, 3-year certificate of deposit at First Wisconsin Bank. What table would be used to determine the amount accumulated at the end of 3 years?

Megan Hoffman invests in a "jumbo" $200,000, 3-year certificate of deposit at First Wisconsin Bank. What table would be used to determine the amount accumulated at the end of 3 years?

Answer: Future value of 1

Costner Inc. wishes to know how much money it will have available in 5 years if five equal amounts of $35,000 are invested, with the first amount invested immediately. What interest table is appropriate for this situation?

Costner Inc. wishes to know how much money it will have available in 5 years if five equal amounts of $35,000 are invested, with the first amount invested immediately. What interest table is appropriate for this situation?

Answer: Future value of an annuity due

On June 1, 2017, Seymour Inc. purchased a new machine that it does not have to pay for until June 1, 2019. The total payment on June 1, 2019, will include both principal and interest. Assuming interest at a 12% rate, the cost of the machine would be the total payment multiplied by what time value of money concept?

On June 1, 2017, Seymour Inc. purchased a new machine that it does not have to pay for until June 1, 2019. The total payment on June 1, 2019, will include both principal and interest. Assuming interest at a 12% rate, the cost of the machine would be the total payment multiplied by what time value of money concept?

Answer: Present value of 1

On May 1, 2017, Goldberg Company sold some machinery to Newlin Company on an instalment contract basis. The contract required five equal annual payments, with the first payment due on May 1, 2017. What present value concept is appropriate for this situation?

On May 1, 2017, Goldberg Company sold some machinery to Newlin Company on an instalment contract basis. The contract required five equal annual payments, with the first payment due on May 1, 2017. What present value concept is appropriate for this situation?

Answer: Present value of an annuity due

In a book named Treasure, the reader has to figure out where a 2.2 pound, 24 kt gold horse has been buried. If the horse is found, a prize of $25,000 a year for 20 years is provided. The actual cost to the publisher to purchase an annuity to pay for the prize is $245,000. What interest rate (to the nearest per cent) was used to determine the amount of the annuity? (Assume end-of-year payments.)

In a book named Treasure, the reader has to figure out where a 2.2 pound, 24 kt gold horse has been buried. If the horse is found, a prize of $25,000 a year for 20 years is provided. The actual cost to the publisher to purchase an annuity to pay for the prize is $245,000. What interest rate (to the nearest per cent) was used to determine the amount of the annuity? (Assume end-of-year payments.)

Answer: 8%

The Kellys are planning for a retirement home. They estimate they will need $200,000 4 years from now to purchase this home. Assuming an interest rate of 10%, what amount must be deposited at the end of each of the 4 years to fund the home price?

The Kellys are planning for a retirement home. They estimate they will need $200,000 4 years from now to purchase this home. Assuming an interest rate of 10%, what amount must be deposited at the end of each of the 4 years to fund the home price?

Answer: 43094

What are the primary characteristics of an annuity? Differentiate between an "ordinary annuity" and an "annuity due."

What are the primary characteristics of an annuity? Differentiate between an "ordinary annuity" and an "annuity due."

An annuity involves (1) periodic payments or receipts, called rents, (2) of the same amount, (3) spread over equal intervals, (4) with interest compounded once each interval.

Rents occur at the end of the intervals for ordinary annuities while the rents occur at the beginning of each of the intervals for annuities due.

Regina Henry deposited $20,000 in a money market certificate that provides the interest of 10% compounded quarterly if the amount is maintained for 3 years. How much will Regina Henry have at the end of 3 years?

Regina Henry deposited $20,000 in a money market certificate that provides the interest of 10% compounded quarterly if the amount is maintained for 3 years. How much will Regina Henry have at the end of 3 years?

Answer: 26898

Jose Oliva is considering two investment options for a $1,500 gift he received for graduation. Both investments have 8% annual interest rates. One offers quarterly compounding; the other compounds on a semiannual basis. Which investment should he choose?

Jose Oliva is considering two investment options for a $1,500 gift he received for graduation. Both investments have 8% annual interest rates. One offers quarterly compounding; the other compounds on a semiannual basis. Which investment should he choose?

Answer: Quarterly compounding

What are the components of an interest rate? Why is it important for accountants to understand these components?

What are the components of an interest rate? Why is it important for accountants to understand these components?

The interest rate generally has three components:

(a) Pure rate of interest—This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation.

(b) The expected inflation rate of interest—Lenders recognize that in an inflationary economy, they are being paid back with less valuable (future) dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high.

(c) Credit risk rate of interest—The U.S. government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc. can have a low or high credit risk.

What is the nature of interest? Distinguish between "simple interest" and "compound interest."

What is the nature of interest? Distinguish between "simple interest" and "compound interest."

Interest is the payment for the use of money. It may represent a cost or earnings depending upon whether the money is being borrowed or loaned. The earning or incurring of interest is a function of the time, as well as the amount of money, and the risk involved (risk may be reflected in the interest rate).

Simple interest is computed on the amount of the principal only, while compound interest is computed on the amount of the principal plus any accumulated interest. Compound interest involves interest on interest while simple interest does not.

Identify three situations in which accounting measures are based on present values. Do these present value applications involve single sums or annuities, or both single sums and annuities? Explain.

Identify three situations in which accounting measures are based on present values. Do these present value applications involve single sums or annuities, or both single sums and annuities? Explain.

(a) Notes receivable and payable—these involve single sums (the face amounts) and may involve annuities if there are periodic interest payments.

(b) Leases—involve measurement of assets and obligations, which are based on the present value of annuities (lease payments) and single sums (if there are residual values and/or bargain purchase options to be paid at the conclusion of the lease).

(c) Pensions and other deferred compensation arrangements—involve discounted future annuity payments that are estimated to be paid to employees upon retirement.

(d) Bond pricing—the price of bonds payable is comprised of the present value of the principal or face value of the bond plus the present value of the annuity of interest payments.

(e) Long-term assets—evaluating various long-term investments or assessing whether an asset is impaired requires determining the present value of the estimated cash flows associated with an investment or long-term asset (maybe single sums and/or an annuity).

What is the time value of money? Why should accountants have an understanding of compound interest, annuities, and present value concepts?

What is the time value of money? Why should accountants have an understanding of compound interest, annuities, and present value concepts?

Money has value because with it one can acquire assets and services and discharge obligations. The holding, borrowing or lending of money can result in costs or earnings. And the longer the time period involved, the greater the costs or the earnings. The cost or earning of money as a function of time is the time value of money.


Accountants must have a working knowledge of compound interest, annuities, and present value concepts because of their application to numerous types of business events and transactions which require proper valuation and presentation. These concepts are applied in the following areas: (1) sinking funds, (2) installment contracts, (3) pensions, (4) long-term assets, (5) leases, (6) notes receivable and payable, (7) business combinations, (8) amortization of premiums and discounts, and (9) estimation of fair value.

What is meant by the elements and items of the terms as they relate to the income statement? Why might items have to be disclosed in the income statement?

What is meant by the elements and items of the terms as they relate to the income statement? Why might items have to be disclosed in the income statement?

Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc.

In order to predict the future, the amounts of individual items may have to be reported. For example, if "income from continuing operations" is significantly lower this year and is reported as a single amount, users would not know whether to attribute the decrease to a temporary increase in an expense item (for example, an unusually large bad debt), a structural change (for example, a change in the relationship between variable and fixed expenses), or some other factor. Another example is income data that are distorted because of large discretionary expenses.

State some of the more serious problems encountered in seeking to achieve the ideal measurement of periodic net income. Explain what accountants do as a practical alternative.

State some of the more serious problems encountered in seeking to achieve the ideal measurement of periodic net income. Explain what accountants do as a practical alternative.

From the revenue side, there are many types of revenue transactions which require estimation. For example, it is difficult to estimate the amount of revenue to recognize for a long-term contract in a given period. Other estimation situations also prevalent such as high rates of return on products sold, net versus gross sales issues, sales with buyback options, estimating revenues in licensing arrangements and so on. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods. Examples of items which present serious obstacles include such items as institutional advertising costs.

Accountants have established certain rules for handling revenues and costs which are applied consistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future.

Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that institutional advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred.

What is meant by "tax allocation within a period"? What is the justification for such practice?

What is meant by "tax allocation within a period"? What is the justification for such practice?

Tax allocation within a period is the practice of allocating the income tax for a period to such items as income from continuing operations, discontinued items, and prior period adjustments.

The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and (a) income before from continuing operations, (b) discontinued operations, and (c) prior period adjustments (or of the opening balance of retained earnings).

What is the basis for distinguishing between operating and nonoperating items?

What is the basis for distinguishing between operating and nonoperating items?

Operating items are the expenses and revenues which relate directly to the principal activity of the company; they are the revenue and expenses which contribute to the sale of goods or services for which a company was organized. The nonoperating section of an income statement is a report of the revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, gains and losses that are infrequent or unusual, or both, are normally reported in the section. Generally these breakdown into two main subsections: "Other revenues and gains" and "Other expenses and losses".

A Wall Street Journal article noted that Apple reported higher income than its competitors by using a more aggressive policy for recognizing revenue on future upgrades to its products. Some contend that Apple's quality of earnings is low. What does the term "quality of earnings" mean?

A Wall Street Journal article noted that Apple reported higher income than its competitors by using a more aggressive policy for recognizing revenue on future upgrades to its products. Some contend that Apple's quality of earnings is low. What does the term "quality of earnings" mean?

The term "quality of earnings" refers to the credibility of the earnings number reported. Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is also considered low.

What is earnings management?

What is earnings management?

Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of "cookie jar" reserves, which are established by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty returns.

How can information base on past transactions be used to predict future cash flows?

How can information base on past transactions be used to predict future cash flows?

Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information.

What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?

What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?

The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the company. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components.

It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company's ability to provide needed goods or services, unions examine earnings closely as a basis for salary discussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy.

What are closing entries and why are they necessary?

What are closing entries and why are they necessary?

Closing entries are prepared to transfer the balances of nominal accounts to capital (retained earnings) after the adjusting entries have been recorded and the financial statements prepared. Closing entries are necessary to reduce the balances in nominal accounts to zero in order to prepare the accounts for the next period's transactions.

What are adjusting entries and why are they necessary?

What are adjusting entries and why are they necessary?

Adjusting entries are prepared prior to the preparation of financial statements in order to bring the accounts up to date and are necessary (1) to achieve proper recognition of revenues and expenses in measuring income and (2) to achieve an accurate presentation of assets, liabilities and stockholders' equity.

What differences are there between the trial balance before closing and the trial balance after closing with respect to the following accounts?

What differences are there between the trial balance before closing and the trial balance after closing with respect to the following accounts?

(a)  Accounts Payable.

(b) Expense accounts.

(c) Revenue accounts.

(d) Retained Earnings account.

(e) Cash.

(a)No change.

(b) Before closing, balances exist in these accounts; after closing, no balances exist.

(c) Before closing, balances exist in these accounts; after closing, no balances exist.

(d) Before closing, a balance exists in this account exclusive of any dividends or the net income or net loss for the period; after closing, the balance is increased or decreased by the amount of net income or net loss, and decreased by
dividends declared.

(e) No change.

Why are revenue and expense accounts called temporary or nominal accounts?

Why are revenue and expense accounts called temporary or nominal accounts?

Revenue and expense accounts are referred to as temporary or nominal accounts because each period they are closed out to Income Summary in the closing process. Their balances are reduced to zero at the end of the accounting period; therefore, the term temporary or nominal is given to these accounts.

Describe the major constraint inherent in the presentation of accounting information.

Describe the major constraint inherent in the presentation of accounting information.

Accounting information is subject to the cost constraint. Information is not worth providing unless the benefits exceed the costs of preparing it

Give an example of a transaction that results in:

(a) A decrease in an asset and a decrease in a liability.

(b) A decrease in one asset and an increase in another asset.

(c) A decrease in one liability and an increase in another liability.

Examples are:

(a) Payment of an accounts payable.
(b) Collection of an accounts receivable from a customer.
(c) Conversion of an accounts payable to a note payable.

Mogilny Company paid $135,000 for a machine. The Accumulated Depreciation—Equipment account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company president believes that the company has a "right to this gain." What does the president mean by this statement?

Mogilny Company paid $135,000 for a machine. The Accumulated Depreciation—Equipment account has a balance of $46,500 at the present time. The company could sell the machine today for $150,000. The company president believes that the company has a "right to this gain." What does the president mean by this statement?

The president means that the difference between the fair value and the book value should be recorded in the books as a 'gain'. This item should not be entered in the accounts, however, because no performance obligation related to this machine has been created or satisfied, GAAP will allow the company to record a gain once the machine is sold and delivered to a buyer.

What is a performance obligation, and how is it used to determine when revenue should be recognized?

What is a performance obligation, and how is it used to determine when revenue should be recognized?

A performance obligation is a promise to deliver a product or provide a service to a customer. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered

What is the fair value option? Explain how the use of the fair value option reflects the application of the fair value principle.

What is the fair value option? Explain how the use of the fair value option reflects the application of the fair value principle.

The fair value option gives companies the option to use fair value (referred to as the fair value option as the basis for measurement of financial assets and financial liabilities.) The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities.

Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them?

Revenues, gains, and investments by owners are all increases in net assets. What are the distinctions among them?

Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity's ongoing major or central operations. Gains arise from peripheral or incidental transactions.

Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them?

Expenses, losses, and distributions to owners are all decreases in net assets. What are the distinctions among them?

Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity's ongoing major or central operations. Losses arise from peripheral or incidental transactions.

What is the distinction between comparability and consistency?

What is the distinction between comparability and consistency?

Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency, a type of comparability, facilitates comparisons between information about the same enterprise at two different points in time.

How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement?

How is materiality (or immateriality) related to the proper presentation of financial statements? What factors and measures should be considered in assessing the materiality of a misstatement in the presentation of a financial statement?

The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation.

Briefly describe the two fundamental qualities of useful accounting information.

Briefly describe the two fundamental qualities of useful accounting information.

Relevance and faithful representation are the two primary qualities of useful accounting information. For information to be relevant, it should be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations. Faithful representation of a measure rests on whether the numbers and descriptions match what really existed or happened.

What is the primary objective of financial reporting?

What is the primary objective of financial reporting?

The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

The Sarbanes-Oxley Act was enacted to combat fraud and curb poor reporting practices. What are some key provisions of this legislation?

The Sarbanes-Oxley Act was enacted to combat fraud and curb poor reporting practices. What are some key provisions of this legislation?

The following are some of the key provisions of the Sarbanes-Oxley Act:

● Establishes an oversight board for accounting practices. The Public Company Accounting Oversight Board (PCAOB) has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules.
● Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years and auditors are prohibited from offering certain types of consulting services to corporate clients.
● Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement.
● Requires audit committees to be comprised of independent members and members with financial expertise.
● Requires codes of ethics for senior financial officers.

In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting.

What is the "expectations gap"? What is the profession doing to try to close this gap?

What is the "expectations gap"? What is the profession doing to try to close this gap?

The expectations gap is the difference between what people think accountants should be doing and what accountants think they can do. It is a difficult gap to close. The accounting profession recognizes it must play an important role in narrowing this gap. To meet the needs of society, the profession is continuing its efforts in developing accounting standards, such as numerous pronouncements issued by the FASB, to serve as guidelines for recording and processing business transactions in the changing economic environment.

What are the sources of pressure that change and influence the development of GAAP?

What are the sources of pressure that change and influence the development of GAAP?

The sources of pressure are innumerable, but the most intense and continuous pressure to change or influence accounting principles or standards come from individual companies, industry associations, governmental agencies, practicing accountants, academicians, professional accounting organizations, and public opinion.

In what way is the Securities and Exchange Commission concerned about and supportive of accounting principles and standards?

In what way is the Securities and Exchange Commission concerned about and supportive of accounting principles and standards?

The SEC has the power to prescribe, in whatever detail it desires, the accounting practices and principles to be employed by the companies that fall within its jurisdiction. Because the SEC receives audited financial statements from nearly all companies that issue securities to the public or are listed on the stock exchanges, it is greatly interested in the content, accuracy, and credibility of the statements. For many years the SEC relied on the AICPA to regulate the profession and develop and enforce accounting principles. Lately, the SEC has assumed a more active role in the development of accounting standards, especially in the area of disclosure requirements. In December 1973, in ASR No. 150, the SEC said the FASB's statements would be presumed to carry substantial authoritative support and anything contrary to them to lack such support. It thereby supports the development of accounting principles in the private sector.

What is the likely limitation of "general-purpose financial statements"?

What is the likely limitation of "general-purpose financial statements"?

General-purpose financial statements are not likely to satisfy the specific needs of all interested parties. Since the needs of interested parties such as creditors, managers, owners, governmental agencies, and financial analysts vary considerably, it is unlikely that one set of financial statements is equally appropriate for these varied uses.

Of what value is a common set of standards in financial accounting and reporting?

Of what value is a common set of standards in financial accounting and reporting?

A common set of standards applied by all businesses and entities provides financial statements which are reasonably comparable. Without a common set of standards, each enterprise could, and would, develop its own theory structure and set of practices, resulting in noncomparability among enterprises

How does accounting help the capital allocation process?

How does accounting help the capital allocation process?

If a company's financial performance is measured accurately, fairly, and on a timely basis, the right managers and companies are able to attract investment capital. To provide unreliable and irrelevant information leads to poor capital allocation which adversely affects the securities market.

Differentiate between "financial statements" and "financial reporting."

Differentiate between "financial statements" and "financial reporting."

Financial statements generally refer to the four basic financial statements: balance sheet, income statement, statement of cash flows, and statement of changes in owners' or stockholders' equity. Financial reporting is a broader concept; it includes the basic financial statements and any other means of communicating financial and economic data to interested external parties. Examples of financial reporting other than financial statements are annual reports, prospectuses, reports filed with the government, news releases, management forecasts or plans, and descriptions of an enterprise's social or environmental impact.

Differentiate broadly between financial accounting and managerial accounting.

Differentiate broadly between financial accounting and managerial accounting.

Financial accounting measures, classifies, and summarizes in report form those activities and that information which relate to the enterprise as a whole for use by parties both internal and external to a business enterprise. Managerial accounting also measures, classifies, and summarizes in report form enterprise activities, but the communication is for the use of internal, managerial parties, and relates more to subsystems of the entity. Managerial accounting is management decision oriented and directed more toward product line, division, and profit center reporting.

Understand Why Companies Select Given Inventory Methods.

Understand Why Companies Select Given Inventory Methods.

Companies ordinarily prefer LIFO in the following circumstances: (1) if selling prices and revenues have been increasing faster than costs and (2) if a company has a fairly constant "base stock." Conversely, LIFO would probably not be appropriate in the following circumstances: (1) if sale prices tend to lag behind costs, (2) if specific identification is traditional, and (3) when unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.

Identify the Major Advantages and Disadvantages of Lifo.

Identify the Major Advantages and Disadvantages of Lifo.

The major advantages of LIFO are the following: (1) It matches recent costs against current revenues to provide a better measure of current earnings. (2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO. (3) Because of the deferral of income tax, cash flow improves. Major disadvantages are: (1) reduced earnings, (2) understated inventory, (3) does not approximate physical flow of the items except in peculiar situations, and (4) involuntary liquidation issues.

Explain the Dollar-value Lifo Method.

Explain the Dollar-value Lifo Method.

Explain the Dollar-value Lifo Method. For the dollar-value LIFO method, companies determine and measure increases and decreases in a pool in terms of total dollar value, not the physical quantity of the goods in the inventory pool.

Understand the Effect of Lifo Liquidations.

Understand the Effect of Lifo Liquidations.

Understand the Effect of Lifo Liquidations. LIFO liquidations match costs from preceding periods against sales revenues reported in current dollars. This distorts net income and results in increased taxable income in the current period. LIFO liquidations can occur frequently when using a specific-goods LIFO approach.

Explain the Significance and Use of a Lifo Reserve.

Explain the Significance and Use of a Lifo Reserve.

Explain the Significance and Use of a Lifo Reserve. The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO, or the LIFO reserve. The change in LIFO reserve is referred to as the LIFO effect. Companies should disclose either the LIFO reserve or the replacement cost of the inventory in the financial statements.