Chapter 3 Measuring and Evaluating Financial Performance

Chapter 3 Measuring and Evaluating Financial Performance Solution Outline for Problem 3.1 As corporations began to take on lives of their own, the owners needed to know how the corporations were performing as time passed. It was not enough to wait for corporations to be wound up at the end of their lives, because that could be a long time. Dispersed ownership also led to a demand for performance measures because shareholders could not just stop in at the offices and ask how things were going. It was not feasible for a corporation with dispersed ownership to invite hundreds or thousands of shareholders into the offices to inspect the records. In any case, the majority of shareholders did not want or need to know the small details of the corporation s operations, instead demanding financial statements that could be relied on as reliable summaries of the records and meaningful periodic measures of performance (results of operations and financial position). Solution Outline for Problem 3.2 The development of accounting concepts standards and principles began when management of companies became separate from their owners. The owners (shareholders) were no longer involved in the day-to-day operations and needed management to provide them with credible financial information. If every company made up its own measurements for financial performance, it would be confusing for the users of the financial statements. For each new investment, a shareholder would have to learn how the company s accounting worked in order to understand if management was running the company well. Other users of financial information also need to evaluate many different companies. For example, taxation authorities would want to tax companies on the same basis so that all companies receive fair (or at least similar) treatment. Solution Outline for Problem 3.3 To answer this, think of the Hudson s Bay Company and its far-flung fur trading empire, managed from across the ocean in London where most of its fur sales were made. A shareholder might be interested in knowing the following about HBC s financial performance: Is the company performing well compared to prior years? Is the company performing well compared to competitors (e.g. The North West Company)? What are the details of its performance, e.g. the value of furs received compared to the value of goods traded in return, any income from land rights sold, types and amounts of expenses incurred to earn revenue? Is the company able to pay dividends? What has it cost to set up trading posts and other necessary facilities? What is the basis of its performance, e.g. buying at good prices, efficient shipping of furs one way and trading goods the other way, or the ability to anticipate the European markets for fur hats and other such items? Solution Outline for Problem 3.4 1. Land is on the balance sheet because it is an asset, that is, a resource owned or controlled and having economic value. Land carries the potential to produce revenues for the company in the future, as do other assets. 2. Assets = $5,222 + $2,410 = $7,632. 49

Financial Accounting: An Integrated Approach, Sixth Edition 3. Share capital is one of the sources of funds used to acquire the assets on the left side of the balance sheet. Therefore, it is not an asset that can be used to purchase more land, but a co-creator of the assets that now exist. Assets can only be used to buy other assets. Therefore, you must use $3,000 cash or another asset to buy a new asset. The company did not have enough cash, since some had already been used to buy inventory and land, so more cash had to be borrowed. 4. Retained earnings is the accumulation of net income minus dividends for each year of the company s history. It is the accumulated residual undistributed earnings of the company and is on the balance sheet because it is a source of present assets (because assets created in the process of earning income were not all distributed to owners). 5. Net income = $10,116 $9,881 = $235. 6. Ending retained earnings were $1,222. Subtracting income that had been added ($235) and adding back dividends that had been deducted ($120) gives beginning retained earnings of $1,107. Proof, going the other way: $1,107 + $235 $120 = $1,222. 7. Ending retained earnings would be $1,107 + $10,116 $11,600 = $377. There would have been a net loss for the year of $1,484, and that would have turned the retained earnings at the beginning into a deficit at the end of $377. 8. If the debit for the deficit were shown among the assets, that would indicate that the company had something of value for the future, a resource that could be used to generate income in the future. This is not at all the case: instead, the company has incurred more expenses than revenue and has, therefore, diminished some of the equity (share capital) put into it by the owners. Its resources were decreased by this, not increased as would be indicated by showing it as an asset. That s why a deficit is deducted from other equity (such as share capital) and shown as a negative item on the right-hand side of the balance sheet. Solution Outline for Problem 3.5 a :8 f: 2 b: 3 g: 4 c: 9 h: 6 d: 7 i: 5 e: 1 j: 10 Solution Outline for Problem 3.6 1. Noranda Inc.: Cost of advertising for new employees. This would be an expense because it is a decrease in wealth incurred to maintain or increase the number of employees working directly or indirectly to earn revenues for Noranda. 2. Royal Bank of Canada: Cost of renovating branch. This could be an expense or an asset, depending on whether the renovations are expected to benefit the current revenue-producing activities (an expense) or if the benefits will also extend to future revenue-producing periods (an asset). 3. Zellers: Increased value of land. This is neither a revenue nor expense since no transaction has occurred yet. A gain (i.e. revenue) can only be recorded if the land under the department stores is sold to an outside party. This would of course, also necessitate the sale of the Zellers department stores. 4. Wendy's Restaurants: Food sold on credit. This would be recorded as revenue of the current period. There has been an increase in wealth arising from the production of hamburgers and so forth and the customers have paid cash. 50

5. The Bay: Whether this is recorded as an expense of the current year depends on whether the customer's lawsuit is likely to be successful, and it is possible to estimate the amount that will be awarded to the customer in the event that his/her lawsuit is successful. If the lawsuit will likely be successful and the amount can be estimated, then it would be recorded as an expense because it is a cost of doing business. 6. Northern Gold Mines Ltd.: Cost of issuing new shares. This would not be treated as an expense of the current year because it is related to transactions with owners and does not contribute to earning revenue in the current year. 7. ABC Travel Agency: Bribes paid to resorts to try to get favourable bookings for clients. These would be an expense of the current period because they help to generate current revenue. To the extent that the payment of bribes may be illegal the Travel Agency may not wish to record this expense. (Accounting tries to reflect economic events, but it also reflects legal constraints: accounting for the Travel Agency could be quite a problem!) 8. Grand Centre Ltd.: Income Taxes paid in France. To be liable for French income taxes it must be the case that the company derives some of its revenues from operations in France. The French income taxes are a cost of doing business in France. To the extent that the income taxes paid are related to current periods earnings in France, they would be an expense of the current period. 9. Advanced Management Ltd.: Special good-performance bonus promised this year but not paid until next year. To the extent that the good-performance bonus relates to performance in the current period, this would be an expense of the current period regardless of when it is paid. 10. Advanced Management Ltd.: Special dividend to owners who are also employees. Dividends are considered a distribution of income to owners, not an expense of producing income; therefore they are not recorded as either revenues or expenses. It makes no difference that employees are also owners of the company. 11. Sears Inc.: Decreased value of the land under some of its inner city locations. The decrease in value will not be recorded as a revenue or expense, but depending on the circumstances it may be recorded as a loss in the current year's income statement. It would not be recorded as an expense because the decrease in value is incidental to the normal business operations of Sears. 12. Proctor & Gamble Inc.: Cost of scientific research aimed at developing new products. This would be appear to be an expense of future periods since the new products are not yet producing revenue in the current period. However, there are special rules that result in research and development expenses being expensed in the current period (even though the research clearly does not directly benefit the current period): there is no identifiable product associated with the research, there is no guarantee that it will benefit future periods, nor is it possible to ascertain which future periods the research might benefit. 13. General Motors Inc.: Estimated amount of money needed to provide pensions to this year's employees when they retire. Pension benefits are a cost of maintaining a work force in the same way that salary expense is. Some of this estimated money would relate to the current period (an expense) and some would relate to future periods (a liability). Actuaries assist in making these estimates. 14. Hattie's Handbags Ltd.: Goods lost to shoplifting. This is an expense of the current period and is usually included in cost of goods sold expense. If Hattie's did not allow any customers in its stores no goods would be stolen, on the other hand no revenue would be generated! 51

Financial Accounting: An Integrated Approach, Sixth Edition 15. Hattie's Handbags Ltd.: Salary of floorwalker. This is an expense of the current period. Although the floorwalker does not generate revenue, he/she hopefully reduces the amount of goods lost to shoplifting, thus increasing net income. 16. PCL Construction Ltd.: Contract payments on five-year construction project. Accounting rules do not allow one to recognize revenue until it is earned. To the extent that work on the project has been performed in the current year and it is possible to estimate the total contract price and total costs of the contract, some revenue may be recognized in the current year. The contract payments themselves would not be recognized as revenue, they would be recorded as a reduction of cost of contracts in progress that is an account much like inventory. Solution Outline for Problem 3.7 Assumptions (all affect the balance sheet only): Receivable amount due from Lucky Eddie appears to have been current because he paid it within a year. Loan to Amalgamated Loansharks also appears to have been current. Wages are payable over a short term; a reasonable assumption is that employees would not allow their wages to remain unpaid for long. Noncurrent liabilities have no current portion payable within the next year. Arctic Limo Services Ltd. Balance Sheet as at September 30, 2006 (with 2005 figures for comparison) 2006 2005 Assets Current assets Cash $ 2,000 $ 4,000 Accounts receivable 0 1,000 $ 2,000 $ 5,000 Noncurrent assets Equipment (limos) $90,000 $60,000 Less accumulated amortization (30,000) (20,000) $60,000 $40,000 Total assets $62,000 $45,000 Liabilities and Equity Current liabilities Loan $ 0 $10,000 Wages payable 2,000 0 $ 2,000 $10,000 Noncurrent liabilities Long-term limo financing $50,000 $30,000 Shareholders equity Share capital $ 1,000 $ 1,000 Retained earnings 9,000 4,000 $10,000 $ 5,000 Total liabilities and equity $62,000 $45,000 52

Arctic Limo Services Ltd. Income Statement for the Year Ended September 30, 2006 Revenue $300,000 Less expenses: Wages $100,000 Other expenses 70,000 Amortization 10,000 $180,000 Income before income tax $120,000 Income tax expense 35,000 Net income $ 85,000 Arctic Limo Services Ltd. Statement of Retained Earnings for the Year Ended September 30, 2006 Beginning balance (September 30, 2005) $ 4,000 Net income for the year 85,000 Dividends declared (80,000) Ending balance (September 30, 2006) $ 9,000 Solution Outline for Problem 3.8 Revenue $6,300,750 COGS $3,518,350 Operating expenses 1,685,300 5,203,650 Operating income $1,097,100 Nonoperating items Interest expense $(207,750) Interest income 20,940 Gain on sale of building 40,000 (146,810) Continuing income before income tax $950,290 Income tax expense 321,300 Income from continuing operations $628,990 Loss on discontinued operations $(300,000) Extraordinary gain 60,000 (240,000) Net income for the year $388,990 Retained earnings, as reported at the end of the prior period $2,527,980 Error correction 4,400 Revised beginning retained earnings $2,532,380 Cost of redeeming shares (27,300) Net income 380,990 Dividends declared (125,000) Ending retained earnings $2,761,070 53

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for Problem 3.9 1. Apparent income statement accounts: Salaries expense Office expenses Employee benefits expense Income tax expense Cash sales revenue Credit sales revenue Amortization expense Interest income Cost of goods sold expense Miscellaneous expenses Insurance expense Interest expense 2. Net income, based on part 1, and using the same account order as no income statement is asked for, just a calculation is: 78,000 13,200 + 33,400 37,200 184,100 13,800 46,200 8,100 + 402,200 + 2,100 9,700 20,500 = 26,900 3. Ending retained earnings = 96,600 + 26,900 14,000 = 109,500 4a. Geewhiz Productions Income Statement for the Year Ended November 30, 2006 Revenue $435,600 Operating expenses * 382,200 Operating income $53,400 Interest expense, net of interest income 18,400 Income before income tax $35,000 Income tax expense 8,100 Net income for the year $26,900 * All expenses are aggregated here. It would be quite acceptable to list them all, though most companies do not because such a list clutters the statement and gives information to competitors. The amount of amortization expense is normally disclosed in a note or by listing that account separately. 4b. Geewhiz Productions Statement of Retained Earnings for the Year Ended November 30, 2004 Retained earnings, beginning of year $96,600 Add net income for the year 26,900 $123,500 Deduct dividends declared (14,000) Retained earnings, end of year $109,500 54

4c. Geewhiz Productions Balance Sheet as at November 30, 2004 Assets Liabilities and Equity Current assets: Current liabilities Cash $27,000 Bank Loan * $37,900 Accounts receivable 18,600 Accounts payable 53,000 Inventory 78,000 Other payables ** 22,000 Prepaid insurance 3,200 $112,900 $126,800 Noncurrent liabilities: Noncurrent assets: Mortgage payable * 169,800 Land $74,000 $282,700 Building 346,000 Shareholders equity: Trucks and equipment 253,400 Share capital $300,000 $673,400 Retained earnings 109,500 Less: accum. amort. 108,000 $409,500 $565,400 $692,200 $692,200 * Bank loan assumed all current; mortgage assumed all noncurrent. ** $3,200 + $6,100 + $5,200 + $7,500 = $22,000 5. Brief points: The company had a positive income, equalling 6.2% of revenue and 6.6% of year-end equity Dividends declared equalled half of the net income, which the board of directors determined was better in the shareholders hands than in the company s. The company had a positive year-end working capital ($126,800 - $112,900 = $13,900; ratio 1.123), so it was likely able to pay its bills on time (as long as it could sell its inventory). The year-end debt-equity ratio was 0.690 ($282,700 / $409,500) so the company was mostly financed by equity and was not particularly risky. Solution Outline for Problem 3.10 Waltzing Matilda's Boutique Ltd. Income Statement for the Month of April 2006 Revenue $11,000 Cost of goods sold expense 5,500 Gross profit $5,500 Operating expenses: Wages $1,500 Insurance 150 Rent 250 Janitor and miscellaneous 670 Office supplies used 75 Amortization 60 2,705 Operating income $2,795 Nonoperating items: Interest 45 Continuing income before income tax $2,750 Income tax expense 550 Net income for April $2,200 55

Financial Accounting: An Integrated Approach, Sixth Edition Waltzing Matilda's Boutique Ltd. Statement of Retained Earnings for April 2006 Retained earnings, March 31, 2006 $3,530 Net income for April 2,200 Retained earnings, April 30, 2006 $5,730 Waltzing Matilda's Boutique Ltd. Balance Sheet as at April 30, 2004 Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 960 Bank loan $ 4,500 Accounts receivable 1,600 Accounts payable 3,200 Inventories* 12,600 Wages, taxes payable*** 2,350 Prepaid expenses** 1,700 $ 10,050 $16,860 Non-current liabilities: Nil Non-current assets: Owners' equity: Store fixtures(cost) $ 3,600 Share capital $ 3,000 Less accum. amort. 1,680 Retained earnings 5,730 $ 1,920 $ 8,730 Total $18,780 $18,780 * $12,000 unsold goods + $600 office supplies. ** $1,200 insurance + $500 rent. *** $750 wages + $1,600 taxes. (It is quite appropriate to list these items separately rather than group them as done here. It is also appropriate to not even mention non-current liabilities, as there are none.) Solution Outline for Problem 3.11 2004 2005 2006 2007 Revenue for the year 38,000 49,000 61,000 65,000 Expenses for the year (except income tax) 29,000 42,000 50,000 61,000 Income before income tax for the year 9,000 7,000 11,000 4,000 Income tax expense for the year 2,000 1,500 3,000 1,000 Net income for the year 7,000 5,500 8,000 3,000 Retained earnings, beg. of the year 21,000 25,000 29,500 33,000 Dividends declared during the year 3,000 1,000 4,500 0 Retained earnings, end of the year 25,000 29,500 33,000 36,000 Other owners equity, end of the year 35,000 38,000 38,000 48,000 Liabilities, end of the year 80,000 85,000 111,000 105,000 Assets, end of the year 140,000 152,500 182,000 189,000 56

Solution Outline for Problem 3.12 Prentice Retail Ltd. Income Statement For Last Year Sales revenue $2,222,610 Operating expenses 1,778,170 Operating income 444,440 Investment revenue 24,810 Continuing income before income taxes 469,250 Income taxes 127,700 Income from continuing operations 341,550 Loss from discontinued operations, net of income tax recovery 40,475 Extraordinary loss on expropriation of land 14,950 Net income for the year $286,125 Prentice Retail Ltd. Statement of Retained Earnings For Last Year Retained earnings, beginning of year as previously reported $354,290 Add correction of error in previous years income 2,430 Retained earnings, beginning of year as restated $356,720 Add net income for the year 286,125 Less dividends declared (87,000) Retained earnings, end of the year $555,845 57

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for Problem 3.13 WideAway Manufacturing Ltd. Balance Sheet as at December 31, 2006 Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 52,000 Bank loan $ 35,000 Accounts receivable 117,000 Accounts payable 98,000 Inventory 116,000 Income taxes payable 27,000 Prepaid expenses 21,000 Current portion of 306,000 mortgage 22,000 182,000 Noncurrent assets: Noncurrent liabilities: Land 100,000 Mortgage (minus current) 242,000 Factory 612,000 Other noncurrent liabilities 16,000 Accum. amort. (236,000) 258,000 476,000 Shareholders equity Share capital 150,000 Retained earnings (below) 192,000 342,000 Total $782,000 $782,000 WideAway Manufacturing Ltd. Statement of Income and Retained Earnings For the Year Ended December 31, 2006 Revenue $949,000 Cost of goods sold 538,000 Gross profit 411,000 Expenses: Operating expenses 229,000 Amortization expense 74,000 303,000 Income before income tax 108,000 Income tax expense 41,000 Net income 67,000 Retained earnings, beginning of year 145,000 Dividend declared (20,000) Retained earnings, end of year $192,000 58

Solution Outline for Problem 3.14 Reasonable assumptions here may lead to different entries than those below. Particular account names are not important. Location a. DR Supplies expense 5,000 Income statement CR Cash (bank) 2,000 Current assets CR Accounts payable 3,000 Current liabilities Purchase of supplies to be used immediately. (Because the supplies are being used immediately, there is no need to record them as an asset.) b. DR Prepaid rent 400 Current assets CR Cash (bank) 400 Current assets Advance payment on vehicle rental contract. c. DR Maintenance expense 300 Income statement CR Cash (bank) 300 Current assets Painting of storage room. d. DR Automotive assets 8,000 Noncurrent assets CR Shareholder loan 8,000 Noncurrent liabilities Purchase of car from shareholder, valued at current market value. (Assumes payment to shareholder is not expected within next year.) e. DR Retained earnings error correction 5,000 Retained earnings CR Accounts payable 5,000 Current liabilities Invoice for last year s repairs received this year. (If, as is likely, this is considered a minor error, the debit would just be made to this year s Maintenance expense, income statement.) Solution Outline for Problem 3.15 Reasonable assumptions here may lead to different answers. Particular account names are not important. a. It is a transaction: an exchange of cash and a promise to repay. Location DR Cash (bank) Cur. ass. 500,000 CR Bank loan Non-cur. liab. 500,000 Bank loan, recorded as a noncurrent liability because payment is not due for 3 years (could also be considered a cash equivalent liability, because of call feature). b. The deposit is a transaction, but the order itself is not as there has been no exchange yet. DR Deposit on order Cur. ass. 10,000 CR Cash (bank Cur. ass. 10,000 Deposit sent with inventory order. 59

Financial Accounting: An Integrated Approach, Sixth Edition c. No transaction because no exchange yet. Exchange comes with occupancy over time. d. No transaction. The legal charge is not an exchange until it is settled or settlement can be predicted. The decline in share price is not an exchange involving Southward as an entity, just its owners. e. The dividend is a transaction as the declaration creates a liability to owners. The share price change again does not involve Southward, just its owners. Location DR Retained earnings Ret. earn. 500,000 CR Dividend payable Cur. liab. 500,000 Declaration of a dividend of $.50 per share on the 1,000,000 shares outstanding, to be paid in one week. f. This is a transaction since the TV has been exchanged for a promise to pay. DR Accounts receivable Cur. ass. 800 CR Revenue Op. rev 800 To record sale of TV DR Cost of goods sold Cur. ass. 580 CR Inventory Op. exp. 580 To transfer cost of TV out of inventory and to COGS. g. Technically, this is not a transaction since the options haven t been exercised yet. However, accounting standards are changing to require companies to recognize stock options as employee benefits. Some companies have already made this change and would therefore record the following journal entry: 60

DR Salaries and benefits expense Op. exp. 120,000 CR Capital stock Equity 120,000 To record granting of stock options. h. This is a transaction since the plumbing services have been exchanged for a promise to pay. Location DR Repairs and maintenance Op. exp. 200 CR Accounts payable Cur. liab. 200 To record invoice for plumbing services received. i. This purchase of the display unit on credit is a transaction since the unit has been exchanged for a promise to pay. the option to buy two more is not a transaction because there has been no exchange. DR Furniture and equipment Non-cur. ass. 750 CR Accounts payable Cur. liab. 750 To record purchase of display unit. Solution Outline for Problem 3.16 This problem in reconstructing journal entries is meant to give students practice in understanding existing accounting data, as distinct from creating the data themselves. The specific wording of entry explanations is not important as long as the intent of each entry is recognized. a. DR Cash 30,000 CR Common shares 30,000 Issue of shares for cash. (Number of shares unknown.) b. DR Inventory 5,000 CR Accounts payable 5,000 Purchases of inventory, on credit. c. DR Equipment 3,600 CR Cash 1,200 CR Notes payable 2,400 Purchase of equipment, partly for cash. d. DR Supplies expense 700 CR Accounts payable 700 Supplies expense, not yet paid for. e. DR Accounts receivable 900 CR Sales revenue 900 Credit sales. 61

Financial Accounting: An Integrated Approach, Sixth Edition DR Cost of goods sold expense 540 CR Inventory 540 Cost of the goods sold on credit. f. DR Cash 1,300 DR Accounts receivable 1,400 CR Sales revenue 2,700 Credit sales with down payment. DR Cost of goods sold expense 1,620 CR Inventory 1,620 Cost of the goods sold with down payment. g. DR Cash 650 CR Accounts receivable 650 Collections on customer accounts. h. DR Accounts payable 1,000 CR Cash 1,000 Payments to suppliers. i. DR Prepaid supplies 300 CR Supplies expense 300 Supplies on hand at end of the month. j. DR Interest expense 60 DR Notes payable 500 CR Cash 560 To record payment of interest and principal on notes. Solution Outline for Problem 3.17 CAUSE JOURNAL ENTRY 1. Repairs of $573 DR Repairs expense 573 obtained on credit CR Accounts payable 573 2. Revenue of $1,520 DR Cash 200 mostly on credit DR Accounts receivable 1,320 CR Revenue 1,520 3. New shares issued DR Cash 2,000 for $2,000 CR Share capital 2,000 4. Dividend of $500 DR Retained earnings 500 declared and paid CR Cash 500 5. Accounts receivable DR Cash 244 of $244 collected CR Accounts receivable 244 6. $1,000 payment DR Mortgage payable 1,000 made on mortgage CR Cash 1,000 7. Inventory purchased DR Inventory 2,320 on credit CR Accounts payable 2,320 62

8. Inventory costing DR Cost of goods sold expense 400 $400 was sold CR Inventory 400 9. Building purchased for DR Building 25,000 $25,000, $5,000 down CR Cash 5,000 CR Mortgage payable 20,000 10. Revenue closed off to DR Revenue 249,320 retained earnings CR Retained earnings 249,320 Solution Outline for Problem 3.18 1. Paid $3,220 on accounts payable DR Accounts payable 3,220 CR Cash 3,220 2. Paid most of income tax expense DR Income tax expense 5,900 CR Cash 5,000 CR Income tax payable 900 3. $200 expense advance provided DR Travel advances rec. 200 CR Cash 200 4. Expense advances accounted for DR Travel expenses 189 DR Cash 11 CR Travel advances rec. 200 5. Customer made a $350 deposit DR Cash 350 CR Customer deposit liab. 350 6. Paid $600 of auditing expense, DR Audit expense 3,000 with the balance on credit CR Accounts payable 2,400 CR Cash 600 7. Shares issued in exchange for equip. DR Equipment 5,200 CR Share capital 5,200 8. Shares redeemed DR Share capital 1,000 CR Cash 1,000 9. Goods costing $2,750 sold DR Cash 1,200 for $4,500, some for cash and DR Accounts receivable 3,300 some on credit CR Revenue 4,500 DR COGS expense 2,750 CR Inventory 2,750 10. COGS closed off to retained DR Retained earnings 147,670 earnings CR COGS expense 147,670 63

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for Problem 3.19 1. An inventory shortage was DR Inventory shortage exp. 387 discovered CR Inventory 387 2. A dividend was declared and DR Retained earnings 5,000 partly paid CR Cash 2,000 CR Dividend payable 3,000 3. The investment was sold at a loss DR Cash 5,000 CR Investment 40,000 DR Loss on investment 35,000 4. Debt was converted into shares DR Long-term debt 10,000 CR Share capital 10,000 5. Inventory was bought, mostly DR Inventory 3,290 on credit CR Cash 748 CR Accounts payable 2,542 6. Bonuses were declared DR Bonuses expense 5,200 CR Bonuses payable 5,200 7. Company seems to have lost DR Lawsuit loss exp. 40,200 a lawsuit DR Legal fees expense 11,340 CR Cash 51,540 8. Money borrowed from the bank DR Cash 32,000 CR Demand loan 32,000 9. Company seems to have bought DR Accounts receivable 24,000 another business DR Inventory 36,000 DR Factory assets 100,000 DR Goodwill 40,000 CR Cash (assumed) 200,000 10. Accounts were closed (a loss) DR Revenues 730,670 CR Expenses 743,210 DR Retained earnings 12,540 64

Solution Outline for Problem 3.20 1. Journal entries for the year ended December 31, 2004. a. DR Cash 5,100 CR Loan from Cline Senior 5,000 CR Share capital 100 b. DR Prepaid expense 120 CR Cash 120 DR Storage expense 120 CR Prepaid expense 120 Done as two entries, one at the beginning of the year, one at the end. No entry for the $130 until 2005. c. DR Buns inventory 500 DR Wieners inventory 1,500 CR Cash 2,000 Purchase of inventory. d. DR Hot dog stands expense 600 CR Cash 100 CR Accounts payable 500 Since the stands were expected only to last this summer, their cost is expensed. DR Hot dog stands expense 60 CR Cash 60 The cost of fixing up the stands. DR Accounts payable 500 DR Interest expense 29 CR Cash 529 Payment on December 31, 2004, of the payable and the interest (which = $500 0.10 7/12 = $29). e. DR Cash 7,000 CR Revenue 7,000 This assumes that hot dog sales were for cash only, none on credit. f. DR Wages expense 2,400 CR Cash 2,400 Student employee s wages. g. DR Cost of goods sold expense 1,960 DR Leftover products expense 40 CR Buns inventory 500 CR Wieners inventory 1,500 Ten dozen buns and wieners remain in inventory. Therefore, 490 dozen were sold during the summer. This entry assumes that the remaining inventory will not last until next summer and sets the inventory on hand to 0. h. DR Income tax expense 358 CR Cash 358 Income before tax = 7,000 120 29 600 60 2,400 1,960 40 = 1,791. Tax = 0.20 $1,791 = $358. i. DR Loan from Cline Senior 5,000 CR Cash 5,000 Repayment to Graham s father. It is assumed here that the father would be repaid before a dividend would be paid to Graham, but the problem does not actually say that, so omitting this entry would not be wrong. 65

Financial Accounting: An Integrated Approach, Sixth Edition j. DR Dividends declared (Retained earnings) 500 CR Cash 500 Dividend: $5 per share 100 shares 2. Graham Cline Inc. Balance Sheet as at December 31, 2004 Assets Liabilities and Equity Cash $1,033 Common shares $ 100 Retained earnings 933 Total Assets $1,033 $1,033 Graham Cline Inc. Statement of Income and Retained Earnings for the Year Ended December 31, 2004 Sales revenue $7,000 Cost of goods sold 1,960 Gross margin $5,040 Operating expenses Leftover products $ 40 Storage 120 Wages 2,400 Interest 29 Hot dog stands 660 Total operating expenses $3,249 Income before income tax $1,791 Income tax expense 358 Net income for the year $1,433 Beginning retained earnings 0 Less dividend declared (500) Ending retained earnings $ 933 3. Graham did make some money. His company earned $1,791 ($1,433 after tax) over the summer and repaid his father, but his employee earned more than that for doing less work (one of the two stands, no management). All that Graham actually received was the $500 dividend. Therefore, Graham should consider whether the venture could be made more viable next year. He may have enjoyed being his own boss, but so far the hot dog stand business seems to have been a marginal one. 66

Solution Outline for Problem 3.21 1. Fergama Productions Inc. Balance Sheet as at the End of Last Year Assets Liabilities and Equity Current assets Current liabilities Cash $ 23,415 Accounts Accounts payable $37,778 receivable 89,455 Taxes payable 12,250 $ 50,028 Supplies inventory 10,240 $123,110 Long-term loan 15,000 Noncurrent assets Shareholders Office equip. equity cost $ 24,486 Share capital $20,000 Accum. amort. (11,134) 13,352 Retained earn. 51,434 71,434 TOTAL $136,462 TOTAL $136,462 2. Entries to record the activities: a. DR Accounts receivable 216,459 CR Revenue 216,459 b. DR Production expenses 156,320 CR Cash 11,287 CR Accounts payable 145,033 c. DR Amortization expense 2,680 CR Accumulated amortization 2,680 d. DR Supplies inventory 8,657 CR Accounts payable 8,657 DR Cost of supplies used expense 12,984 CR Supplies inventory 12,984 e. DR Income tax expense 12,319 CR Income tax payable 12,319 f. DR Retained earnings 25,000 CR Dividend payable 25,000 g. DR Cash 235,260 CR Accounts receivable 235,260 h. DR Accounts payable 172,276 CR Cash 172,276 i. DR Income tax payable 18,400 CR Cash 18,400 j. DR Long-term loan 5,000 CR Cash 5,000 k. DR Dividend payable 25,000 CR Cash 25,000 3. Ending trial balance: DR CR Cash 26,712 Accounts receivable 70,654 Supplies inventory 5,913 Office equipment 24,486 Accumulated amortization 13,814 Accounts payable 19,192 Income tax payable 6,169 Dividend payable 0 Long-term loan 10,000 Share capital 20,000 Retained earnings beginning 51,434 Dividend 25,000 Revenue 216,459 Production expenses 156,320 Amortization expense 2,680 Cost of supplies used expense 12,984 Income tax expense 12,319 337,068 337,068 67

Financial Accounting: An Integrated Approach, Sixth Edition Fergama Productions Inc. Balance Sheet as at the End of This Year Assets Liabilities and Equity Current assets Current liabilities Cash $26,712 Accounts Accounts payable $19,192 receivable 70,654 Taxes payable 6,169 $ 25,361 Supplies inventory 5,913 $103,279 Long-term loan 10,000 Noncurrent assets Shareholders Office equip. equity cost $24,486 Share capital $20,000 Accum. amort. (13,814) 10,672 Retained earn. 58,590 78,590 TOTAL $113,951 TOTAL $113,951 4. Income statement has revenue of $216,459, income before income tax of $44,475, and net income of $32,156. Retained earnings adds that to the beginning retained earnings of $51,434, subtract dividends and show ending retained earnings of $58,590. Balance sheet (end of this year) has current assets (cash, accounts receivable, and supplies) $103,279, noncurrent assets (office equipment minus accumulated amortization) net $10,672, total assets $113,951, current liabilities (accounts payable and taxes payable) $25,361, the long-term loan of $10,000, equity (share capital and retained earnings) $78,590, and total liabilities and shareholders equity $113,951. 5. Is the company better off than last year? Well, first, substantial net income was earned this year, around 15% of revenue. By the definition of net income, the company has increased its net resources (assets minus liabilities). While most of this income was paid as a dividend to the owners, not all of it was, so the retained earnings are higher than last year. Regarding current position, the working capital was $73,082 last year and is higher, $77,918, this year. The working capital ratio was 2.46 last year and is 4.07 this year. So it appears that the company is better off this year than last. (More ways of answering this question are developed in later chapters.) Solution Outline for Problem 3.22 a. DR Inventory 283,500 CR Accounts payable 283,500 DR Accounts payable (283,500-37,400) 246,100 CR Cash 246,100 b. DR Wages expense 103,770 CR Cash 76,760 CR Cash 15,590 CR Wages payable 9,790 CR Emp. deductions due 1,630 c. DR Cash 255,760 CR Revenue 421,270 DR Accounts receivable 165,510 DR Cash (165,510-19,160) 146,350 CR Accounts receivable 146,350 68

d. DR COGS expense 212,390 CR Inventory 212,390 DR Shoplifting expense 3,580 CR Inventory 3,580 e. DR Other expenses 58,500 CR Cash 56,540 CR Accounts payable 1,960 f. DR Income tax expense 10,750 CR Income tax payable 10,750 g. DR Retained earnings 10,000 CR Dividend payable 10,000 DR Investment 50,000 CR Cash 50,000 69

Financial Accounting: An Integrated Approach, Sixth Edition Beginning Transactions Ending Cash 100,000 (246,100) (76,760) (15,590) 255,760 57,120 146,350 (56,540) (50,000) Accounts receivable 165,510 (146,350) 19,160 Inventory 283,500 (212,390) (3,580) 67,530 Investment 50,000 50,000 Accounts payable (283,500) 246,100 (1,960) (39,360) Wages payable (9,790) (9,790) Deductions due (1,630) (1,630) Income tax payable (10,750) (10,750) Dividend payable (10,000) (10,000) Shareholders loan (65,000) (65,000) Share capital (35,000) (35,000) Retained earnings 10,000 10,000 Revenue (421,270) (421,270) COGS expense 212,390 212,390 Shoplifting expense 3,580 3,580 Wages expense 103,770 103,770 Other expenses 58,500 58,500 Income tax expense 10,750 10,750 0 0 0 70

Frothingsloth Beverages Inc. Statement of Income and Retained Earnings For the Year Ended 20XX Revenue $421,270 COGS expense 212,390 Gross margin $208,880 Expenses Wages $103,770 Shoplifting 3,580 Other 58,500 165,850 Income before tax $ 43,030 Income tax expense 10,750 Net income $32,280 Beginning retained earnings 0 $32,280 Dividend declared 10,000 Ending retained earnings $22,280 Frothingsloth Beverages Inc. Balance Sheet As at 20XX Current assets: Current liabilities: Cash $ 57,120 Accounts payable $ 39,360 Short-term investment 50,000 Wages payable 9,790 Accounts receivable 19,160 Emp. deductions due 1,630 Inventory 67,530 Income tax payable 10,750 $193,810 Dividend payable 10,000 $ 71,530 Noncurrent liabilities: Shareholder loan 65,000 $136,530 Shareholder s equity: Share capital $ 35,000 Retained earnings 22,280 $ 57,280 TOTAL $193,810 TOTAL $193,810 71

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for Problem 3.23 DR Revenue 421,270 CR COGS expense 212,390 CR Shoplifting expense 3,580 CR Wages expense 103,770 CR Other expenses 58,500 CR Income tax expense 10,750 CR Retained earnings 32,280 Post-closing trial balance would be as Ending columns above (solution outline for Problem 3.22) for balance sheet accounts except retained earnings now = 22,280. All revenue and expense accounts will be zero. Solution Outline for Problem 3.24 a. Recording amortization DR Amortization expense b. Recognizing interest cost that is building up DR Interest expense c. Capitalizing expense(s) CR Relevant expense(s) d. Recognizing unexpired insurance coverage CR Insurance expense e. Recognizing estimated warranty costs on DR Warranty expense this year s revenue f. Recording dividends declared DR Retained earnings g. Estimating current income tax liability DR Income tax expense h. Removing customer deposits from revenue DR Revenue i. Unused supplies on hand CR Relevant expense (eg supplies) j. Recognizing year-end bonus DR Bonuses expense Solution Outline for Problem 3.25 Comments and necessary adjustments for SOS: a. DR Inventory 11,240 CR Accounts payable 11,240 b. DR Interest expense 330 CR Accrued interest liability 330 c. Not an event to be adjusted for external to the company. d. DR Amortization expense 14,500 CR Accumulated amortization 14,500 e. DR Bad debts expense or loss 2,100 CR Accounts receivable or allowance for doubtful accounts 2,100 f. DR Warranty expense 780 CR Warranty liability 780 g. Not an event to be adjusted for not effective until next year. 72

h. DR Prepaid expenses 2,000 CR Insurance expense 2,000 (10/12 $2,400) i. DR Sales revenue 400 CR Customer deposits liability 400 j. DR Accounts receivable 7,200 CR Sales revenue 7,200 DR COGS expense 3,300 CR Inventory 3,300 Solution Outline for Problem 3.26 a. DR Accounts receivable or cash 3,124 CR Sales revenue 3,124 b. DR Sales revenue 500 CR Deferred revenue liability 500 c. DR Interest expense 620 CR Accrued interest payable 620 0.08 x 123,000 x (23/365) = 620 d. DR Cost of goods sold or Inventory loss 1,278 CR Inventory 1,278 e. DR Travel expenses 1,823 CR Advances to employees 1,823 f. DR Bad debt expense 320 CR Accounts receivable 320 g. DR Pension expense 38,940 CR Current pension liability 38,940 h. DR Loss on patent write-off 32,400 DR Accumulated amortization 42,100 CR Patent asset 74,500 i. DR Expenses 5,430 CR Accounts payable 5,430 j. DR Retained earnings 150,000 CR Dividend payable 150,000 73

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for 3.27 Location a. DR Office and cleaning expense Inc. stmnt. 114 CR Accounts payable Curr. liab. 114 DR Prepaid supplies Curr. ass. 382 CR Office and cleaning expense Inc. stmnt. 382 Unrecorded liability for cleaning and office supplies ($114) and supplies still on hand ($382) at the end of the year. (These items are very small and might be ignored.) b. DR Accounts receivable Curr. ass. 11,621 CR Sales revenue Inc. stmnt. 11,621 Uncollected but earned revenue at the end of the year. (This follows from the company's apparent practice of recognizing revenue only upon collection.) c. DR Raw materials inventory Curr. ass. 6,210 CR Raw materials expense Inc. stmnt. 6,210 Raw materials on hand at the end of the year. d. DR Prepaid tools expense Curr. ass. 238 CR Tools and parts expense Inc. stmnt. 238 Small tools and parts on hand at the end of the year. (This amount is very small and might be ignored.) e. Probably no journal entry would be made because the advertising would be considered an expense of the next year, to be matched against the revenue next year that the advertising would help to generate. (If it were desired to record the invoice, the $900 could be credited to accounts payable and debited to prepaid advertising.) f. DR Equipment and fixtures Non-c. ass. 2,316 CR Repairs and maintenance expense Inc. stmnt. 2,316 Capitalizing expenditures originally charged to expense. (This would require some evidence of asset value beyond the president's suggestion.) g. DR Mortgage interest expense Inc. stmnt. 187 CR Accrued interest liability Curr. liab. 187 Accrued mortgage interest at the end of the year. (This amount is small and might be ignored.) h. DR Retained earnings Equity 14,000 CR Dividend payable Curr. liab. 14,000 Dividend declared before the year-end, to be paid two months hence. 74

i. DR Bonuses expense Inc. stmnt. 3,058 CR Bonus payable Curr. liab. 3,058 General manager's bonus, 8% of $38,226 pre-tax and pre-bonus income, to be paid in three months. (The need to calculate this bonus may mean that even small adjustments, such as a, d and g above, will be made so that there is no argument about the bonus. It also would give the general manager a personal interest in adjustments such as f.) Solution Outline for Problem 3.28 1. a. DR Bad debts expense 2,400 CR Accounts receivable 2,400 b. DR Amortization expense 13,000 CR Accum. amortization 13,000 c. DR Accounts receivable 11,200 CR Revenue 11,200 d. DR COGS expense 4,600 CR Inventory 4,600 e. DR Operating expense 900 CR Accrued interest liability 900 f. DR Operating expense 5,000 CR Bonus payable 5,000 g. DR Income tax expense 2,700 CR Income tax payable 2,700 2. and 3. Unadjusted Adjustments Adjusted DR CR DR CR DR CR Cash 25,600 25,600 Accounts receivable 88,200 (c) 11,200 (a) 2,400 97,000 Inventory 116,900 (d) 4,600 112,300 Land 100,000 100,000 Buildings & equip. 236,100 236,100 Accum. amortization (b)13,000 13,000 Accounts payable 74,900 74,900 Employee deductions due 2,500 2,500 Sales taxes due 3,220 3,220 Accrued interest (e) 900 900 Bonus payable (f) 5,000 5,000 Income tax payable (g) 2,700 2,700 Mortgage 185,780 185,780 Share capital 275,000 275,000 Retained earnings 0 0 Revenue 349,600 (c) 11,200 360,800 COGS expense 142,500 (d) 4,600 147,100 Operating expenses 181,700 (a) 2,400 203,000 (b) 13,000 (e) 900 (f) 5,000 Income tax expense (g) 2,700 2,700 891,000 891,000 39,800 39,800 923,800 923,800 4. DR Revenue 360,800 CR COGS expense 147,100 CR Operating expenses 203,000 CR Income tax expense 2,700 CR Retained earnings 8,000 75

Financial Accounting: An Integrated Approach, Sixth Edition 5. Net income = $8,000 (see part 4) Current assets = $25,600 + $97,000 + $112,300 = $234,900 Current liabilities = $74,900 + $2,500 + $3,220 + $900 + $5,000 + $2,700 = $89,220 Working capital = $234,900 $89,220 = $145,680 Shareholders equity = $275,000 + $8,000 = $283,000 Solution Outline for Problem 3.29 1. (a) DR Insurance expense 1,800 CR Prepaid insurance 1,800 (b) DR Supplies expense 600 CR Supplies on hand 600 (c) DR Amortization expense 4,000 CR Accumulated amortization 4,000 2.& 4. (d) DR Salaries expense 800 CR Salaries payable 800 (e) DR Unearned rest 2,400 CR Rent revenue 2,400 (f) DR Utilities expense 300 CR Miscellaneous payables 300 (g) DR Interest expense 100 CR Miscellaneous payables 100 (h) DR Advertising expense 300 CR Miscellaneous payables 300 Unadjusted Trial Balance Adjusting entries Adjusted Trial Balance DR CR DR CR DR CR Cash $ 9,900 9,900 Short-term investment 15,000 15,000 Accounts receivable 12,000 12,000 Prepaid insurance 3,600 (a)1,800 1,800 Supplies on hand 1,500 (b)600 900 Truck 34,000 34,000 Accumulated Nil (c)4,000 4,000 amortization Accounts payable 15,000 15,000 Salaries payable (d)800 800 Miscellaneous payables (f)300 (g)100 (h)300 700 76

Current portion longterm 2,000 2000 bank loan Long-term bank loan 20,000 20,000 Unearned rent 7,200 (e)2,400 4,800 Common stock 20,000 20,000 Revenue 40,100 40,100 Rent revenue (e)2,400 2,400 Advertising expense 2,600 (h)300 2,900 Commissions expense 3,000 3,000 Amortization expense (c)4,000 4,000 Insurance expense (a)1,800 1,800 Supplies expense (b)600 600 Interest expense 800 (g)100 900 Salaries expense 21,000 (d)800 21,800 Utilities expense 900 (f)300 1,200 TOTAL 104,300 104,300 10,300 10,300 109,800 109,800 3. LEAKEY PENS INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2006 Sales revenue $40,100 Rental revenue 2,400 Total revenue 42,500 Expenses: Advertising expense 2,900 Commissions expense 3,000 Amortization expense 4,000 Insurance expenses 1,800 Supplies expense 600 Interest expense 900 Salaries expense 21,800 Utilities expense 1,200 Total expenses 36,200 Income before income taxes 6,300 Income taxes 1,575 Net income 4,725 Solution Outline for Problem 3.30 (i) *all figures are in millions a. DR Accounts receivable 35.9 CR Freight revenue 35.9 b. DR Depreciation and amortization 12.4 CR Net properties 12.4 77

Financial Accounting: An Integrated Approach, Sixth Edition c. DR Interest expense 15.3 CR Accounts payable and accrued liabilities 15.3 d. DR Dividends common shares 5.2 CR Dividends payable on Common Shares 5.2 e. DR Fuel (expense) 42.3 CR Accounts payable and accrued liabilities 42.3 f. DR Income tax expense 8.7 CR Income and other taxes payable 8.7 ii) Unadjusted Adjustments Adjusted DR CR DR CR DR CR Cash and short-term inv t 353.0 353.0 Accounts receivable 434.7 (a) 35.9 470.6 Materials and supplies 134.1 134.1 Future income taxes 70.2 70.2 Investments 96.0 96.0 Net properties 8,393.5 (b) 12.4 8,381.1 Other assets 1,018.3 1,018.3 Accts pay/accrued liab. 975.3 (c) 15.3 1,032.9 (e) 42.3 Inc. and other taxes pay. 16.2 (f) 8.7 24.9 Dividends payable 21.0 (d) 5.2 26.2 Long-term debt-current 275.7 275.7 Deferred liabilities 767.8 767.8 Long-term debt 3,075.3 3,075.3 Future income taxes 1,386.1 1,386.1 Share capital 1,120.6 1,120.6 Cont. surplus 300.4 300.4 Foreign currency adj. 77.0 77.0 Retained income-beg. 2,153.9 2,153.9 Dividends common 82.5 (d) 5.2 87.7 Freight revenue 3,728.8 (a) 35.9 3,764.7 Other revenue 174.1 174.1 Comp. and benefits 1,259.6 1,259.6 Fuel 440.0 (e) 42.3 482.3 Materials 178.5 178.5 Equipment rents 218.5 218.5 Deprec/amortization 407.1 (b) 12.4 419.5 Purchased serv. and other 610.7 610.7 Special charges 71.9 71.9 Other charges 36.1 36.1 Foreign exchange gain on long-term debt 94.4 94.4 Interest expense 218.6 (c) 15.3 233.9 Income tax expense 143.3 (f) 8.7 152.0 14,166.6 14,166.6 119.8 119.8 14,274.0 14,274.0 78

iii) The financial statements shown below are in summary form, in millions of dollars. Canadian Pacific Railway Limited Statement of Consolidated Income Year-ended December 31, 2004 Revenue $3,938.8 Operating expenses 3,169.1 Operating income before the following 769.7 Spin-off charges 71.9 Operating income 697.8 Non-operating expenses 327.6 Net income $370.2 Canadian Pacific Railway Limited Statement of Consolidated Retained Income Year-ended December 31, 2004 Balance, January 1, as restated $2,153.9 Net income for the year 370.2 Dividends (87.7) Balance, December 31 $2,436.4 Canadian Pacific Railway Limited Consolidated Balance Sheet As at December 31, 2004 Current assets $957.7 Noncurrent assets 9,565.6 Total assets $10,523.3 Current liabilities $1,359.7 Noncurrent liabilities 5,229.2 Total liabilities $6,588.9 Shares and other equity $1,498.0 Retained income 2,436.4 Total shareholders equity $3,934.4 Total liabilities and shareholders equity $10,523.3 79

Financial Accounting: An Integrated Approach, Sixth Edition Solution Outline for Problem 3.31 1. $5,400,000 would be the smoothest net income because it varies the least from the prior year. 2. Arguments for including all of the contract s revenue and expenses in 2009: to increase net income and therefore improve performance in the eyes of investors; to increase net income and possibly the managers bonuses. Arguments for including all of the contract s revenue and expenses in 2010: to delay payment of income taxes on the contract s profit; to reduce shareholders dividend expectations; to take advantage of a Big Bath situation by worsening the current year s results in order for future results to look even better. Arguments for including a portion of the contract s revenue and expenses in 2009: to result in smoother income and an impression of good management from year to year; this approach falls between the extremes of the other alternatives and so perhaps balances conservatism and aggressiveness; this approach is probably more common than the other two combined. Arguments could also be advanced for each possibility in terms of how the accounting reflects the economic reality of the transaction. 3. The company should choose the most appropriate accounting method that represents the essence of the transactions that have taken place. Methods should be applied consistently from one period to the next. Solution Outline for Problem 3.32 1. DR Goodwill write-down 50,000,000 CR Goodwill 50,000,000 2. The write down of goodwill will have no effect on the company s cash position since the transaction does not affect cash. The write-down of goodwill only affects the perceived value of the acquired companies. Additionally, it will reduce retained earnings thus decreasing the equity portion of the balance sheet. 3. Bill is not correct if he is referring to the company s ability to pays its creditors or operate. The large loss does not affect cash or creditors thus there is no effect on the stability of the company. In the short run, the loss devastates the quarterly and annual earnings. Also, investors may lose confidence in the company and management for the takeover s of overly priced companies. In the long run, the company may benefit when revenues begin to increase because they have gotten rid of a large item that would have had to been amortized in future years. Also, by clearing the balance sheet of items that have a lower market worth, it is easier for investors to gauge the true financial position of the company. Solution Outline for Problem 3.33 Would it be better to spread out the loss? Probably not. Conservatism drives many accounting practices. If it is believed that goodwill or other such assets have declined in value then they should be written down immediately so as not to inflate the numbers on the balance sheet. From the investors point of view, a loss reported all at once will result in a better valuation of the company s current financial position. The investors may not react much to a low-income figure in the current year if it was going to be low anyway. From management s point of view, they can put all of the bad news into one quarter and take a massive loss when there would have been a smaller one anyway. 80