Principles of Accounting, Tenth Edition

Principles of Accounting, Tenth Edition Answers to Stop, Review, and Apply Questions Chapter 14 The Corporate Income Statement and the Statement of Stockholders Equity 1-1. Quality of earnings refers to the substance of earnings and their sustainability into future accounting periods. Gains and losses on transactions, write-downs and restructurings, and nonoperating items are components of the income statement that affect quality of earnings. 1-2. The reader of financial statements is interested in a company s choice of accounting methods and estimates because of their effect on the company s quality of earnings. For example, by shortening the period over which it depreciates long-term assets, a company can increase its quality of earnings. 1-3. A write-down is a reduction in the value of an asset below its carrying value on the balance sheet. A restructuring is the estimated cost of a change in a company s operations; it usually involves the closing of facilities and layoff of personnel. Both write-downs and restructurings reduce current operating income and boost future income by shifting future costs to the current accounting period. Both appear in the operating (top) portion of a corporate income statement. 1-4. Cash flows relate to quality of earnings in that if earnings have underlying cash flows, they are considered more sustainable and of higher quality. Thus, a company with low earnings and high cash flows has higher quality earnings than a company with high earnings and low cash flows. 2-1. Accounting income and taxable income should not be treated alike because they serve different purposes. The purpose of accounting income is to give some indication (however imperfect) of a business s financial status; the sole purpose of taxable income is to provide a basis for collecting government revenues. Income tax allocation is necessary because of differences between accounting and taxable income caused by the timing of revenues and expenses. 2-2. Deferred income taxes represent the difference between income tax expense and income tax payable. If the former is greater than the latter, a deferred income tax liability exists. 2-3. On the income statement, net of taxes means that income taxes have been allocated among the various components of the statement so that each item, such as a gain or loss, is shown at an amount that is net of any tax consequences. 3-1. A gain or loss on discontinued operations should be disclosed separately on the income statement because separating the results of continuing operations and discontinued operations enhances the usefulness of the statement. It enables users to evaluate the company s ongoing activities and make projections about future operations.

3-2. The two major criteria for extraordinary items are that they be unusual in nature and that they occur infrequently. Extraordinary items should be disclosed separately from continuing operations on the income statement, and extraordinary gains or losses should be shown net of applicable taxes. 4-1. Earnings per share are disclosed on the income statement and usually appear immediately below the net income figure. They are broken down into income from continuing operations, income before extraordinary items, and net income. If a company reports a gain or loss from discontinued operations or extraordinary items, earnings per share figures are presented for those as well. If a company has potentially dilutive securities, diluted earnings per share must be shown. 4-2. A company has a simple capital structure when it has issued no preferred stocks, bonds, or stock options that can be converted to common stock. A company that has issued securities or stock options that can be converted to common stock has a complex capital structure. 4-3. Diluted earnings per share differ from basic earnings per share in that they take into account the effect of all potentially dilutive securities on earnings per share. 5-1. Comprehensive income consists of items from sources other than stockholders that account for the change in stockholders equity during an accounting period. Comprehensive income includes net income, changes in unrealized investment gains and losses, gains and losses from foreign currency translation, and other items affecting equity. 5-2. The statement of stockholders equity summarizes changes in the components of the stockholders equity section of the balance sheet that occurred during an accounting period. The stockholders equity section of the balance sheet lists the items of contributed capital and retained earnings on the balance sheet date. 5-3. A company has a deficit in retained earnings when its dividends and subsequent losses exceed its accumulated profits from operations. 6-1. Accounting for a stock dividend and accounting for a cash dividend differ in that in accounting for a cash dividend, dividends payable is credited, and in accounting for a stock dividend, common stock distributable and additional paid-in capital are credited for the amount of the stock dividend measured at market value. 6-2. A stock dividend is a proportional distribution of newly issued shares of stock to stockholders. A stock split divides the shares already owned by stockholders into additional shares according to a predetermined ratio. Both increase the number of shares outstanding. 6-2. A stock dividend results in a transfer of ownership interest from retained earnings to contributed capital. A stock split changes the number and par value of the common stock; it does not change the dollar amount in retained earnings or contributed capital. 7-1. When a corporation has no preferred stock, the book value per share is determined by dividing stockholders equity by the number of common shares outstanding.

7-2. Book value per share is based on total assets minus total liabilities. Because assets are usually recorded at historical cost, one would not expect book value per share to equal market value per share. Chapter 15 The Statement of Cash Flows 1-1. In the statement of cash flows, cash includes both cash and cash equivalents. Cash equivalents are short-term (ninety days or less), highly liquid investments, such as money market accounts, commercial paper, and U.S. Treasury bills. 1-2. The primary purpose of the statement of cash flows is to provide information about a company s cash receipts and cash payments during an accounting period. A secondary purpose is to provide information about a company s operating, investing, and financing activities during the period. 1-3. Cash flows are classified under operating, investing, and financing activities. Cash flows related to operating activities include cash receipts from customers for goods and services and from interest and dividends on investments; cash payments for wages, goods, and services; interest paid on debt; and taxes paid. Cash flows related to investing activities include cash received from the sale of long-term assets and marketable securities and the collection of loans, and cash expended for purchases of long-term assets and marketable securities and the making of loans. Cash flows related to financing activities include proceeds from issues of stock, long-term debt, and short-term borrowings; repayment of loans; the purchase of treasury stock; and payments made to owners, including cash dividends. 1-4. Significant noncash investing and financing transaction do not affect current cash flows, but they will affect cash flows in the future. They are therefore disclosed in a separate schedule on the statement of cash flows. 1-5. Analysts consider cash flows from operations an important indicator of the cash flows that underlie earnings, or the quality of earnings. Thus, a company may try to make its cash flows from operating activities look better by placing items that belong in the operating section of the statement of cash flows in the investing or financing sections. 2-1. Cash-generating efficiency is a company s ability to generate cash from current or continuing operations. 2-2. Three ratios that measure cash-generating efficiency are cash flow yield, cash flows to sales, and cash flows to assets. 2-3. Free cash flow is the cash that remains after deducting the funds a company must commit to continue operating at its planned level. 2-4. If free cash flow is positive, it means that the company has met all its planned cash commitments and has cash available to reduce debt or to expand. A negative free cash flow means that the company will have to sell investments, borrow money, or issue stock in the short term to continue at its planned level.

3-1. The direct method adjusts each item on the income statement from an accrual basis to a cash basis. The indirect method does not require the adjustment of each item on the income statement; it lists only the adjustments necessary to convert net income to cash flows from operations. 3-2. A company can have a positive cash flow from operations despite a net loss if it has (1) large amounts of noncash expenses, such as depreciation and amortization; (2) large reductions in accounts receivable, inventories, or other prepaid assets; or (3) large increases in accounts payable, accrued liabilities, or income taxes payable. A positive cash flow occurs if the amount of any one of these items or their combined amount is greater than the net loss. 3-3. Depreciation is deducted from net income on the income statement, but it does not require a cash outlay and so does not affect cash flows in the current period. Thus, to arrive at cash flows from operating activities on the statement of cash flows, depreciation must be added back to net income. 3-4. The cash from the sale of an asset, which includes the amount of a gain, is included in the investing activities section of the statement of cash flows. The gain is also included in net income in the operating activities section. It is deducted in this section to prevent double counting. 3-5. Changes in current assets and current liabilities represent amounts by which the accrual accounting numbers for net income differ from the actual cash received or paid. Thus, adjustments are necessary to convert the accrual-based net income to cash flows from operating activities. 3-6. When the indirect method is used to determine net cash flows from operating activities, (a) an increase in accounts receivable should be subtracted from net income, (b) a decrease in inventory should be added, (c) an increase in accounts payable should be added, (d) a decrease in wages payable should be subtracted, (e) depreciation expense should be added, and (f) amortization of patents should be added. 4-1. The two major categories of assets that relate to the investing activities section of the statement of cash flows are investments and plant assets. 4-2. A building that cost $50,000, that had accumulated depreciation of $32,000, and that is sold at a loss of $5,000 would result in an increase in cash flow of $13,000 (carrying value of $18,000 less the loss of $5,000). The transaction should be shown as the sale of a building for $13,000 in the investing activities section of the statement of cash flows. If the indirect method is used, the $5,000 loss should be added to net income to determine net cash flows from operating activities. 4-3. The transaction should be disclosed on the schedule of noncash investing and financing transactions that accompanies the statement of cash flows, as follows: Issue of mortgage for buildings and land, $234,000.

5-1. The major categories of liabilities and stockholders equity that relate to the financing activities section of the statement of cash flows are long-term liabilities, stock issues and repurchases (treasury stock), and cash dividends. 5-2. The conversion of bonds to common stock does not involve cash and does not appear in the financing section of the statement of cash flows. It should, however, be listed in the schedule of noncash investing and financing transactions that accompanies the statement of cash flows. Chapter 16 Investments 1-1. Investments are generally recorded on the date they are made and are valued at cost, which includes any commissions. 1-2. Trading securities are debt or equity securities bought and help principally for the purpose of being sold in the near term. Available-for-sale securities are debt or equity securities that may be sold at any time. Held-to-maturity securities are debt securities that a company intends to hold until their maturity date. 1-3. In accounting for equity investments, the level and percentage of ownership are important because they are factors in determining how the investments should be treated. 1-4. Disclosure of investments is important because it describes how the investments are classified and the methods used to account for them. 1-5. Insider trading is the unethical and illegal practice of using inside information (information not available to the public) for personal gain. 2-1. Trading securities are valued at fair value on the balance sheet date. 2-2. Unrealized gains and losses on trading securities are the differences between the securities costs and current market values. They are reported on the income statement. 2-3. Unrealized gains and losses on trading securities are the differences between the securities costs and current market values. They are reported on the income statement. 2-3. Accounting for available-for-sale securities differs from accounting for trading securities in two ways: (1) an unrealized gain or loss is reported as a special item in the stockholders equity section of the balance sheet, not as a gain or loss on the income statement; (2) if a decline in the value of a security is considered permanent, it is charged as a loss on the income statement. 3-1. a. Less than 20 percent ownership constitutes a noninfluential and noncontrolling investment; the cost-adjusted-to-market method should be used. b. A 20 to 50 percent ownership constitutes an influential but noncontrolling investment; the equity method should be used. c. More than 50 percent ownership constitutes a controlling investment; consolidated financial statements should be prepared.

3-2. A parent-subsidiary relationship exists when a company (the parent) owns more than 50 percent of the voting stock of another company (the subsidiary). 3-3. Although information about American Home Products Corporation s subsidiaries may be helpful in assessing the corporation s performance, stockholders would be interested primarily in its consolidated financial statements because they give an overview of the entire economic entity. 3-4. Under the equity method, the parent company increases or decreases its investment in subsidiaries according to its share of their earnings and dividends. The equity method is required when the parent in this case, Merchant Corporation has significant influence over a subsidiary. 4-1. Eliminating entries prevent duplication of accounts in the records of a parent and its subsidiaries and reflect the financial position and operations of the consolidated entity. They are not entered in the accounting records; they appear only on the work sheets used in preparing consolidated financial statements. 4-2. Consolidated statements are valuable because they show the parent and all its subsidiaries as a single operating entity. 4-3. The practice violates the rule that all majority-owned subsidiaries must be consolidated. 4-4. Minority interest represents the holdings of owners of less than 50 percent of a subsidiary s voting stock. Minority interest appears on the consolidated balance sheet between long-term liabilities and stockholders equity or as a separate item in the stockholders equity section. 4-5. Goodwill from consolidation arises if a parent company (Merchant, in this case) pays more for an investment in a subsidiary than the fair value of the subsidiary s net assets. Goodwill from consolidation is shown on the balance sheet as a separate intangible asset. 4-6. To avoid double counting and overstating accounts, intercompany receivables, payables, sales, and purchases must be eliminated from consolidated financial statements. Only transactions with outside parties should be presented. 4-7. The amount of sales on the consolidated income statement is $1,400,000, or the sales of both companies minus the intercompany sales ($500,000 + $1,000,000 - $100,000). 4-8. Before consolidating the financial statements of foreign subsidiaries and their parent company, the foreign subsidiaries financial statements must be translated into the parent company s currency. 5-1. Held-to-maturity securities are debt securities that management intends to hold until their maturity date. They are valued on the balance sheet at cost adjusted for the effects of interest. 5-2. Most long-term bond investments are classified as available-for-sale securities because companies generally do not expect to hold them until their maturity date.

Chapter 17 Financial Performance Measurement 1-1. Both investors and creditors use financial performance evaluation in choosing investments that will provide a return commensurate with the risk involved. Each group, however, evaluates a different type of risk. Investors evaluate the risk that dividends and stock price will not meet the required rate of return. Creditors evaluate the risk that a debtor will default on a loan. 1-2. The degree of risk involved in making a loan or investment depends on how easy it is to predict a company s future liquidity or profitability. In return for taking a greater risk, a creditor may demand a higher interest rate, and an investor may look for a higher return. 1-3. Three commonly used standards of comparison for evaluating financial statements are rule-of-thumb measures, a company s past performance, and industry norms. Rule-of-thumb measures are the weakest approach because they do not take into consideration a company s individual characteristics. Comparison of a company s financial measures or ratios over time can be effective, but this standard must be used with care. Industry norms are useful in showing how a company compares with other companies in the same industry. 1-4. A financial analyst might compare Steelco s ratios with those of other steel companies to determine how Steelco ranks in the industry. If Steelco has characteristics that make it different from other steel companies, this comparison would not be valid. 1-5. The major sources of information about public corporations are reports published by the company, reports filed with the SEC, business periodicals, and credit and investment advisory services. Much of this information is available on the Internet. 1-6. A corporation s compensation committee, which is made up of independent directors appointed by the board of directors, is charged with determining how top executives will be paid. The common components of executive compensation are salary, bonuses, and stock options. 2-1. Both horizontal and trend analyses focus on a company s performance over time. However, horizontal analysis focuses on performance from one year to the next, whereas trend analysis has a long-term perspective. Thus, an investor would want to see both types of analyses. 2-2. The statement means that net income in 1990 was set equal to 100 and that net income in 2000 and 2001 was recomputed, or indexed, in reference to net income in 1990. That is, net income in 2000 was 240 percent of net income in 1990 and increased to 260 percent of that figure in 2001. 2-3. Horizontal analysis is a year-to-year analysis of the components of various financial statements. Vertical analysis is concerned with the relationship of items within a single financial statement.

2-4. The purpose of ratio analysis is to identify meaningful relationships between components of the financial statements. 3-1. Although these two companies have the same net income, without more information, it is impossible to conclude that they are equally successful. For example, if one of them had twice as many assets as the other, its return on assets (a measure of profitability) would be only half of the other company s. 3-2. Because Circo Company has a return on assets of 12 percent and a debt to equity ratio of.5, one would expect its return on equity to be more than 12 percent because of its ability to use financial leverage. 3-3. With a profit margin of less than 1 percent, a supermarket would have to maintain a high asset turnover to achieve a satisfactory return on assets. 3-4. The amount of net cash flows from operating activities is common to all cash flow adequacy ratios. These ratios are most closely related to the liquidity and long-term solvency ratios. 3-5. The ratios most relevant to determining the financing period are days sales uncollected, days inventory on hand, and days payable. The longer a company s financing period (Days Sales Uncollected + Days Inventory on Hand Day s Payable), the greater its financing or interest costs will be. Thus, determining the financing period is especially important in periods of high interest rates. 3-6. To determine whether investors are equally confident about the future of Companies J and Q, one would compare the companies price/earnings (PE) ratios. The P/E ratio is computed by dividing a company s market price by its earnings per share. A high P/E ratio indicates that investors have a high degree of confidence in a company s future earnings and therefore are willing to accept a lower rate of return. Chapter 18 The Changing Business Environment: A Manager s Perspective 1-1. Management accounting is the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating financial and nonfinancial information used by management to plan, evaluate, and control an organization and to ensure that resources are used and accounted for appropriately. Management accounting is similar to financial accounting in that both are responsible for summarizing information and reporting it to interested parties. Moreover, both are part of an organization's management information system. For this reason, much of the information used to report to external parties can also be used internally to help managers plan, control, and make decisions. In addition, management accountants may develop information systems that are useful to financial accountants. For example, information from the inventories information system can be used to report inventory costs on the balance sheet. 1-2. The supply chain is the path that leads from the sources of materials that products are made out of to the final consumer. Products or services flow from suppliers to manufacturers to distributors to retailers to consumers in the supply chain.

1-3. a. Why? Why is this report being prepared? This question is important because it establishes the report's characteristics and is instrumental in answering the other three questions. b. Who? For whom is the report being prepared? To whom will the report be distributed? Who will read it? The answers to these questions are important because they dictate the report's format. c. What? What information should the report contain to satisfy the purpose decided upon in the why question? At this point, the presentation method is established. This question is important because it results in a report that is relevant and easy to read. d. When? When is the report due? This question is important because information is useful only if it is timely. Since quick reports sometimes lack accuracy, a tradeoff between accuracy and urgency may be necessary. 1-4. The writer should include a clear statement of the assumptions underlying the report and the conditions under which the estimates and projections were made. This will enable the reader to assess how valid the estimates and projections are. 2-1. The value chain is a way of defining a business as a set of primary and support processes that link together to provide products and services to customers to achieve the business s mission and objectives. 2-2. Each primary process in the value chain adds value to the final product or service of a business. Support services facilitate the primary processes but do not add value to the final product or service. The primary processes are research and development, design, supply, production, marketing, distribution, and customer service; the support services to the value chain are human resources, legal services, information systems, and management accounting. 2-3. A company needs to be good at both. However, it is more important to have a primary process as a core competency because primary processes add value to the final product, and it is on the basis of primary processes that a company distinguishes itself from its competitors. 3-1. Managers must first develop measures that reflect the quality they seek. They must then carefully monitor these measures and report the results on a regular basis. 3-2. All the management approaches described in this chapter have perfection by means of continuous improvement as their goal. By continuously trying to improve operations, all contribute to the same basic results: reduced product or service costs and throughput time, and increased product or service quality and customer satisfaction. 4-1. The balanced scorecard is balanced in the sense that it weighs the needs of the four perspectives of an organization to achieve the organization s mission. 4-2. Performance measures are quantitative tools that are used to gauge an organization's performance in relation to a specific process, activity, task, or expected outcome. Examples of financial performance measures include return on investment, net income as a percentage of sales, and the costs of poor quality as a percentage of sales. Examples of nonfinancial performance measures include number of customer

complaints, number of orders shipped the same day, hours of inspection, and time to fill an order. 4-3. The balanced scorecard provides a framework for measuring and evaluating performance from a variety of viewpoints. The scorecard links the interdependent goals of all stakeholder groups to the organization's mission, performance measures, strategic plan, and resources. 5-1. Both are important. Nonfinancial data are important for measuring the performance of business processes, but ultimately these data are translated into budgets and financial reports that reflect the financial objectives of the company. 5-2. From the information provided, it appears that machines 1 and 3 may not be operating efficiently and need further analysis. 6-1. Your first step should be to discuss the situation with your immediate superior unless he or she is involved, in which case you should discuss the situation with someone at a higher level. You may have to take the matter to the board of directors or to the authorities. If you cannot resolve it, your last resort is to resign. 6-2. Integrity is the foundation on which the accounting profession is built. Without integrity, the accountant has no role on the management team. Management accountants are expected to provide impartial, accurate, and relevant information that recipients can rely on. Their integrity makes this possible. Chapter 19 Cost Concepts and Cost Allocation 1-1. Managers use information about costs to plan (estimate operating costs and sales volume, set prices, and prepare budgets); to perform (monitor profitability, make decisions concerning products and services, and compute the unit cost of a product or service); to evaluate (compute variances between estimated and actual costs and analyze variances, address causes, and revise future plans); and to communicate (prepare internal reports for management and external reports for stakeholders). 1-2. Different organizations have different types of costs. Service organizations need information about the costs of providing services, retail organizations need information about the costs of purchasing products for resale, and manufacturing organizations need information about the costs of manufacturing products. 2-1. Managers use different cost classifications to select and use relevant information to improve the efficiency of operations, provide quality products or services, and satisfy customer needs. 2-2. Direct costs of a product are traceable; however, indirect costs are often difficult to trace and therefore managers use a formula to assign them. 2-3. A value-adding cost increases the market value of a product or service, whereas a nonvalue-adding cost adds cost to a product or service but does not increase its market value.

2-4. Product costs are costs assigned to inventory, such as direct materials, direct labor, and overhead. Period costs are costs of resources used during the accounting period that are not assigned to products. 3-1. Because service organizations sell services and not products, they maintain no inventories for sale or resale and thus have no inventory accounts on their balance sheets. Because retail organizations purchase products ready for resale, they maintain just one inventory account on the balance sheet, the Merchandise Inventory account. Because manufacturing organizations make products for sale, they maintain three inventory accounts on the balance sheet: Materials Inventory, Work in Process Inventory, and Finished Goods Inventory. 3-2. The Work in Process Inventory account accumulates the cost information used in the statement of cost of goods manufactured. 3-3. The cost of goods sold is computed by adding the beginning balance of the Finished Goods Inventory account to the cost of goods manufactured to arrive at the total cost of finished goods available for sale and then subtracting the ending balance in Finished Goods Inventory. 4-1. The Materials Inventory account shows the balance of unused direct materials. The cost of direct materials purchased increases the balance, and the cost of direct materials used by the production decreases this account. The Work in Process Inventory account records the balance of partially completed units of the product. The costs of direct materials, direct labor, and overhead (called total manufacturing costs) are transferred to the Work in Process Inventory account and increase its balance. The cost of all units completed and moved to finished goods inventory (called the cost of goods manufactured) decreases the balance of the Work in Process Inventory account. The Finished Goods Inventory account holds the balance of costs assigned to all completed products that a manufacturing company has not yet sold. The cost of goods manufactured increases the balance, and the cost of goods sold decreases the balance. 4-2. Manufacturing cost flow is the flow of manufacturing costs (direct materials, direct labor, and overhead) through the Materials Inventory, Work in Process Inventory, and Finished Goods Inventory accounts into the Cost of Goods Sold account. 4-3. Total manufacturing costs increase the balance of the Work in Process Inventory account, whereas the cost of goods manufactured decreases the balance of the Work in Process Inventory account. 5-1. The three elements of product costs are direct materials costs, direct labor costs, and overhead costs. 5-2. Production-related costs that cannot be practically or conveniently traced directly to an end product are considered overhead costs. They include indirect materials costs and indirect labor costs. 5-3. The three elements of product cost direct materials, direct labor, and overhead may differ in amount depending on whether the actual, normal, or standard costing

method is used. Actual costing calculates the product unit cost by summing the actual per-unit costs of direct materials, direct labor, and overhead. Actual product cost is calculated at the end of the accounting period when actual costs are known. Normal costing combines the actual costs of direct materials and direct labor with an estimated overhead cost to determine the normal product cost per unit. Normal costing is used during the accounting period to provide estimated information about product costs for management decision making. 6-1. A cost pool is a collection of overhead costs related to a cost object (the recipient of an assigned, or allocated cost). A cost driver is an activity that causes the cost pool to increase in amount as the cost driver increases. An example of a cost object in a computer manufacturing company is a computer. A cost pool could be the dollar amount of the inspection costs. A cost driver for the inspection activity could be the number of inspections. 6-2. A predetermined overhead rate enables managers to make decisions about pricing products or services and controlling costs before some of the actual costs are known. It also allows managers to apply overhead costs to each unit produced in an equitable and timely manner. 6-3. a. Planning the overhead rate. Managers determine cost pools and cost drivers and calculate a predetermined overhead rate by dividing the cost pool of total estimated overhead costs by the total estimated cost driver level. b. Applying the overhead rate. As units of the product or service are produced, the estimated overhead costs are assigned to the product or service using the predetermined overhead rate. c. Recording actual overhead costs. The actual overhead costs are recorded as they are incurred. d. Reconciling the applied and actual overhead amounts. At the end of the accounting period, the difference between the applied and actual overhead costs is calculated and reconciled. An adjustment is made for overapplied or underapplied overhead costs, whether they are immaterial or material, to reflect the actual overhead costs on the income statement. 7-1. One overhead cost pool is used in the traditional approach to cost allocation. 7-2. Direct labor hours, direct labor costs, machine hours, or units of production are examples of cost drivers used in the traditional approach to allocating overhead. 8-1. Traditional overhead allocation uses one overall cost pool and a traditional activity base or cost driver, such as direct labor hours, direct labor costs, machine hours, or units of production. Activity-based costing creates many smaller activity pools from the single overhead cost pool used in the traditional method. Because the cost drivers associated with each of these activity cost pools are more closely associated with the causes of the costs, more accurate allocations can be made. 8-2. In the ABC approach to cost allocation, managers use as many cost pools as are needed for effective and efficient management of overhead costs.

8-3. A cost driver is used to associate an activity pool with a cost object. Because the cost driver is a measure of a production-related activity and the events and circumstances that cause that activity, it is a good basis for assigning indirect costs. Chapter 20 Costing Systems: Job Order and Process Costing 1-1. When managers of manufacturing organizations plan, they use cost information to budget costs, forecast product prices, and plan production volumes. Managers of service organizations use cost information to develop budgets, establish prices, set sales goals, and determine human resource needs. In both kinds of organizations, managers use cost information to determine performance expectations. 1-2. Managers use cost information to make decisions about whether to drop a product or service, add a production shift, outsource the manufacture of parts or tasks, bid on a special order or service proposal, negotiate a selling price, or add staff. 1-3. When managers evaluate results, they watch for changes in cost or quality by comparing actual and targeted total and unit costs as well as relevant price and volume information. Managers analyze such information to evaluate the organization's performance and adjust planning and decision-making strategies. 2-1. A product costing system is a set of procedures used to account for an organization's product costs and provide timely and accurate unit cost information for pricing, cost planning and control, inventory valuation, and financial statement preparation. 2-2. The main similarity between a job order costing system and a process costing system is that both provide information about product unit cost that managers can use to price products, control costs, value inventory, and prepare financial statements. The main difference is that a job order costing system traces product costs to a specific job order or batch of products and uses a single Work in Process Inventory account to summarize the costs of all jobs. This account is supported by job order cost cards. A process costing system traces the production costs to processes, departments, or work cells. A process costing system uses several Work in Process Inventory accounts one for each process, department, or work cell. 2-3. Most companies use hybrid systems that combine features of both job order costing and process costing to meet the specific needs of the business. 3-1. The Work in Process Inventory account is used to record the manufacturing costs incurred and allocated to partially completed units of product. 3-2. At year end, actual overhead costs for the period are reconciled with the estimated overhead costs that were allocated so that when the financial statements are prepared, the cost of goods sold will reflect the actual overhead costs incurred. 3-3. The main difference is that in a service organization, costs are not associated with a physical product that can be assembled, stored, and valued. Services are rendered and cannot be held in inventory. As a result, service organizations have few or no costs for materials. The most important costs in a service organization are labor and overhead. Any material costs are incidental and referred to as supplies.

4-1. Companies that produce large amounts of similar products or liquid products or that have long, continuous production runs of identical products use a process costing system. Companies that make unique or special-order products use a job order costing system. 4-2. Unlike a job order costing system, a process costing system is not limited to one Work in Process Inventory account. Process costing uses as many Work in Process Inventory accounts as there are processes, departments, or work cells in the production process. The product unit cost in a process costing system consists of one set of costs from each process, department, or work cell through which a product passes. 5-1. Equivalent production, a key factor in the computation of product unit costs in a process costing system, is a measure of equivalent whole units produced during a period of time. Partially completed units are restated in terms of equivalent whole units. The number of equivalent units produced is equal to the sum of (a) total units started and completed during the period and (b) an amount representing the work done on partially completed units in both the beginning and the ending work in process inventories. A percentage of completion factor is applied to partially completed units to compute the number of equivalent whole units. 5-2. Actual unit data must be converted to equivalent unit data to compute true per unit direct materials costs and conversion costs. Restating partially completed units in terms of equivalent whole units allows the appropriate amount of direct materials costs and conversion costs to be applied to all products worked on during a period. 5-3. Conversion costs are the combined total of direct labor and overhead costs incurred by a production process, department, or work cell. The two costs are combined because both are often incurred uniformly throughout the making of the product or service, and so adding them together saves one unit cost computation. 6-1. a. Account for physical units. b. Account for equivalent units. c. Account for costs. d. Compute cost per equivalent unit. e. Assign costs to cost of goods manufactured and ending inventory. 6-2. The purpose of accounting for costs in a process report is to track and analyze costs for a process, department, or work cell in a process costing system. 6-3. The two important dollar amounts are cost of goods manufactured and ending inventory. The cost of manufacturing is part of the cost of goods sold on an income statement, and ending inventory can be found on the balance sheet. 6-4. One process cost report is prepared each period for every Work in Process Inventory account. 7-1. By analyzing the information from a job order or process costing system, managers can compare budgeted and actual costs. They can also track units produced and monitor labor costs to evaluate operating performance.

7-2. a. Tracking units produced per time period helps managers evaluate how efficiently an organization is operating. b. Monitoring labor cost per unit produced helps managers evaluate how well the organization is utilizing its labor force. c. Keeping track of customer needs can help managers determine if their efforts are focused in the right areas and can significantly enhance customer relationships. Chapter 21 Activity-Based Systems: ABM and JIT 1-1. A company generates revenue when customers see value in its products or services and therefore buy them. As a result, companies measure customer value by looking at the revenue generated. To create value and satisfy customers needs, managers can work with suppliers, view their organization as a collection of value-adding activities, use resources for value-adding activities, reduce or eliminate nonvalueadding activities, and know the total cost of creating value for a customer. 1-2. The main focus of an activity-based system is on managing activities rather than costs. 1-3. Gathering quantitative information at the activity level provides managers with flexible cost pools for assignment to different types of cost objects. For example, the costs of the selling activity can be assigned to a customer group, a sales territory, or a product line. 2-1. Activity-based management (ABM) is an approach to managing a business that involves identifying all major operating activities, determining what resources are consumed by each activity and the cause of the resource usage, and categorizing the activities as either adding value to a product or service or not adding value. ABM benefits both strategic planning and operational decision making because it provides financial and operational performance information at the activity level that is useful for making decisions about business segments, such as product lines, market segments, and customer groups. It also helps managers eliminate waste and inefficiencies and redirect resources to activities that add value to the product or service. 2-2. A supply chain focuses on external relationships, whereas a value chain focuses on internal relationships. 3-1. Customers are not willing to pay for such activities, which is why businesses try to minimize or eliminate them. 3-2. Process value analysis (PVA) is an analytical method of identifying all activities and relating them to the events that cause or drive the need for the activities and the resources consumed. 4-1. Many organizations have turned to activity-based costing because they realized that the traditional methods of using direct labor hours, direct labor costs, or machine hours as cost drivers to allocate overhead costs were not only inaccurate but also were causing poor pricing decisions.

4-2. The five steps of activity-based product costing are (1) identify each activity and classify it into one of the four categories of the cost hierarchy, (2) estimate the cost of resources for each activity, (3) identify all cost drivers and estimate the quantity of each cost driver, (4) calculate an activity cost rate, and (5) assign all costs to cost objects based on the level of activity required to make the product or provide the service. 4-3. For a company, unit-level activities are performed each time a unit of product or service is produced. Batch-level activities are performed each time a batch or production run of goods or services is made. Product-level or service-level activities are performed to support a certain line or brand of products or services. Facility-level or operations-level activities are performed to support an organization's general production process. 4-4. A bill of activities includes not only the product or service costs found on a job order cost card, but also the costs of all relevant operating activities. 5-1. The objectives of a JIT operating environment are to enhance productivity, eliminate waste, reduce costs, and improve product quality. 5-2. When an organization uses pull-through production, a customer's order triggers the purchase of materials and the scheduling of production for the required products. This approach is in sharp contrast to the push-through method, where products are manufactured and stored in anticipation of customers' orders. The pull-through approach is a fundamental characteristic of the JIT operating environment. 5-3. In the traditional manufacturing environment, inspection is a separate function. JIT incorporates inspection into the continuous production operation. Machine operators are responsible for inspecting products as they pass through the process. When the operators detect a product flaw, production is stopped until the cause of the problem is determined. Operators may even help the engineer or quality control person find a way to correct the process. 6-1. Processing time is value-adding time in the production process. 6-2. Under JIT, costs associated with inspection, moving, queue, and storage time should be reduced or eliminated because they do not add value to the product. Only costs associated with processing time are classified as either direct materials costs or conversion costs. 7-1. Backflush costing is commonly used to account for product costs in a JIT operating environment. When backflush costing is used, all product costs are first accumulated in the Cost of Goods Sold account. Then, at period end, the costs are flushed back, or worked backward, into the appropriate inventory accounts. This approach saves recording time because all product costs flow straight to a final destination. Then, at period end, the ending balances are transferred to the inventory accounts. Time is also saved because several accounts are eliminated and fewer transactions are recorded. ABM does not use backflush costing since it tracks costs first to activities or cost pools and then assigns those activity costs to products. Recordkeeping time is not reduced, although product costing accuracy improves.

7-2. The ending balance in the Finished Goods Inventory account is the difference between the cost of goods sold and the cost of goods completed. 8-1. Activity-based management uses activity-based costing to calculate the costs of products or services more accurately. In a just-in-time system, backflush costing is used to identify all the product or service costs of units completed in a shorter and less costly time period through the elimination of some traditional accounting steps such as materials inventory and work-in process inventory. 8-2. Yes, a business can use both of these activity-based systems. Chapter 22 Cost Behavior Analysis 1-1. Cost behavior is the way in which costs respond to changes in volume or activity. Total variable costs increase or decrease in direct proportion to the number of units (or services) produced. Total fixed costs remain relatively constant over the accounting period, even with changes in productive output. Some costs are mixed, exhibiting characteristics of both variable and fixed costs. 1-2. Managers use cost behavior information in most decisions, including the analysis of changes in operating income, the estimation of future revenues, and the preparation of budgets. Knowledge of cost behavior is also useful in determining the effects of decisions on operating income. 2-1. Normal capacity is the average annual level of operating capacity required to satisfy anticipated sales demand. The sales demand figure is adjusted for seasonal business factors and operating cycles. Normal capacity is a realistic measure that expresses what will be produced not what can be produced by an operating unit over a specific period. Theoretical capacity is the maximum productive output for a given period, assuming all of the department s or organization s machinery and equipment are operating at optimum speed, without interruption. Although the concept is useful for estimating maximum output capability, it bears no relationship to day-to-day operations. Practical capacity is theoretical capacity reduced by normal and anticipated work stoppages. No organization operates at theoretical, or practical capacity. 2-2. The relevant range of activity includes all the potential levels of volume within which actual operations are likely to occur and within which fixed costs remain constant in total. Once volume increases beyond the relevant range, total fixed costs also increase. 2-3. In total, fixed costs remain constant over a given period. This means that the greater the number of units produced in that period, the lower the fixed cost per unit. 2-4. A mixed cost is a cost that has both variable and fixed cost components. Part of the cost changes with volume or usage, and part of the cost is fixed over the period. An example is the cost of electricity. 3-1. Cost-volume-profit analysis is an examination of the cost behavior patterns that underlie the relationships among cost, volume of output, and profit.

3-2. C-V-P analysis is used to forecast future operations: to predict profit when sales volume is known, to determine the sales volume necessary to reach a target profit, and to budget. For cost control purposes, C-V-P relationships provide a means of measuring the performance of various departments or operating segments in an organization. 3-3. The following conditions must exist for C-V-P analysis to be accurate: The behavior of variable and fixed costs can be measured accurately. Costs and revenues have a close linear approximation. Efficiency and productivity hold steady within the relevant range of activity. Cost and price variables hold steady during the period being planned. The sales mix does not change during the period being planned. Production and sales volume are roughly equal. 4-1. The breakeven point is the point at which total revenues equal total costs; it is the point (in sales units or dollars) at which an organization begins to generate a profit. Breakeven analysis gives managers valuable information about how production levels relate to profitability. 4-2. Contribution margin is the amount that remains after variable costs are subtracted from sales. As a result, the breakeven point can be expressed as the point at which contribution margin minus total fixed costs equals zero, or the point at which contribution margin equals total fixed costs. 4-3. At zero sales, there is zero revenue; at zero sales and production, there is no variable cost, yet fixed costs still exist. 5-1. Target Sales Units = Fixed Costs + Target Profit Contribution Margin per Unit 5-2. Service businesses can use C-V-P analysis to make decisions about the level of volume and fees for services needed to cover operating costs, the sales mix of services required to break even (in a company providing multiple services), and the impact on profits when variable or fixed operating costs change. 5-3. Both types of organizations will use the same formula for breakeven analysis, which requires a selling price or fee, a volume of sales activity, and variable and fixed costs. For manufacturing companies, the variable costs for manufacturing, selling, and administrative activities are separated from the fixed costs for the same set of activities. For service organizations, the variable costs of labor, service overhead, and selling and administrative activities are separated from the fixed costs for the same set of activities. Because no products are manufactured in the course of providing services, service organizations have no materials costs. Chapter 23 The Budgeting Process 1-1. A budget is a plan of action that forecasts future transactions, activities, and events in financial or nonfinancial terms. A budget can reflect financial information based on