CHAPTER 3 ACCRUAL ACCOUNTING CONCEPTS

CHAPTER 3 ACCRUAL ACCOUNTING CONCEPTS CLASS DISCUSSION QUESTIONS 1. Google and Wal-Mart use the accrual basis of accounting. Generally accepted accounting principles (GAAP) require all but very small businesses to use the accrual basis of accounting. This is because the accrual basis provides for a better analysis and interpretation of profitability of the business as reported on the income statement. The effects of operations on the cash of the business are reported in the cash flows from operating activities section of the statement of cash flows. 2. a. Under the cash basis of accounting, revenues are reported in the period in which cash is received, and expenses are reported in the period in which cash is paid. b. Under the accrual basis of accounting, revenues are reported in the period in which they are earned, and expenses are reported in the period in which they are incurred in producing revenues. 3. a. 2011 b. 2010 4. a. 2011 b. 2010 5. Accrual basis only: c, f Cash or accrual basis: a, b, d, e 6. Yes. Land needs no adjustment at the end of the period. 7. No. Supplies before adjustments normally represents the cost of the supplies at the beginning of the period plus the cost of the supplies purchased during the period. Some of the supplies have been used; therefore, an adjustment is necessary for the supplies used before the amount for the balance sheet is determined. 8. Adjustments are necessary at the end of an accounting period to bring accounts up to date prior to preparing financial statements. 9. Four different categories of adjustments include deferred expenses (prepaid expenses), deferred revenues (unearned revenues), accrued expenses (accrued liabilities), and accrued revenues (accrued assets). 10. Statement (b): Increases the balance of an expense account (Ex: accrued expense). 11. Statement (a): Increases the balance of a revenue account (Ex: accrued revenue). 12. Yes, because every adjustment affects expenses or revenues. 13. a. The portion of the cost of a fixed asset deducted from revenue of the period is recorded by increasing Depreciation Expense. Depreciation expense is the expired cost for the period. The reduction in the fixed asset account is recorded by increasing Accumulated Depreciation rather than decreasing the fixed asset account. The use of the contra asset account facilitates the presentation of original cost and accumulated depreciation for tax and other purposes. b. No, it is not customary for the balances of the two accounts to be equal in amount. Depreciation Expense represents the current-year portion of the fixed asset cost that has expired. Accumulated Depreciation is the cumulative depreciation of the asset up to that point in time. c. Depreciation Expense appears in the income statement; Accumulated Depreciation appears in the balance sheet. 14. a. Current assets are composed of cash and other assets that may reasonably be expected to be realized in cash or sold or consumed in the near future (within a year or less) through the normal operations of the business. b. Property, plant, and equipment are composed of assets used in the business that are of a permanent or relatively fixed nature. 61

E3 1 EXERCISES Statement of 32,500 20,150 3,000 17,150 Balance Sheet Income Cash Flows Assets = Liabilities + Stockholders Equity Statement Prepaid Accounts Capital Retained Cash + Supplies + Ins. = Payable + Stock + Earnings a. Investment 20,000 20,000 b. Paid insurance 7,200 7,200 Balances 12,800 7,200 20,000 c. Purchased supplies 1,200 1,200 Balances 12,800 1,200 7,200 1,200 20,000 d. Fees earned 32,500 32,500 d. Balances 45,300 1,200 7,200 1,200 20,000 e. Paid expenses 12,350 12,350 e. Balances 32,950 1,200 7,200 1,200 20,000 f. Paid dividends 3,000 Balances 29,950 1,200 7,200 1,200 20,000 Statement of Cash Flows Income Statement a. Financing 32,500 8,000 2,500 1,000 850 20,000 d. Fees earned b. Operating 7,200 e. Wages exp. d. Operating 32,500 e. Rent exp. e. Operating 12,350 e. Utilities exp. f. Financing 3,000 e. Misc. exp. Increase in cash 29,950 62

E3 2 Statement of Balance Sheet Income Cash Flows Assets = Liabilities + Stockholders Equity Statement Prepaid Accounts Capital Retained Cash + Supplies + Ins. = Payable + Stock + Earnings a. Investment 20,000 20,000 b. Paid insurance 7,200 7,200 Balances 12,800 7,200 20,000 c. Purchased supplies 1,200 1,200 Balances 12,800 1,200 7,200 1,200 20,000 d. Fees earned 32,500 32,500 d. Balances 45,300 1,200 7,200 1,200 20,000 32,500 e. Paid expenses 12,350 12,350 e. Balances 32,950 1,200 7,200 1,200 20,000 20,150 f. Paid dividends 3,000 3,000 Balances 29,950 1,200 7,200 1,200 20,000 17,150 a1. Insurance expense 600 600 a1. Balances 29,950 1,200 6,600 1,200 20,000 16,550 a2. Supplies expense 550 550 a2. Balances, May 31 29,950 650 6,600 1,200 20,000 16,000 Statement of Cash Flows Income Statement a. 32,500 8,000 2,500 850 600 550 19,000 Financing 20,000 d. Fees earned b. Operating 7,200 e. Wages exp. d. Operating 32,500 e. Rent exp. e. Operating 12,350 e. Utilities exp. 1,000 f. Financing 3,000 e. Misc. exp. Increase in cash 29,950 a1. Ins. exp. a2. Supplies exp. Net income 63

E3 3 LUV CARE Income Statement For the Month Ended May 31, 2011 Fees earned... $32,500 Operating Expenses: Wages expense... $8,000 Rent expense... 2,500 Utilities expense... 1,000 Insurance expense... 600 Supplies expense... 550 Miscellaneous expense... 850 Total expenses... 13,500 Net income... $19,000 LUV CARE Retained Earnings Statement For the Month Ended May 31, 2011 Net income... $19,000 Less dividends... 3,000 Retained earnings, May 31, 2011... $16,000 64

E3 3, Concluded LUV CARE Balance Sheet May 31, 2011 Assets Cash... $29,950 Supplies... 650 Prepaid insurance... 6,600 Total assets... $37,200 Liabilities Accounts payable... $ 1,200 Stockholders Equity Capital stock... $20,000 Retained earnings... 16,000 Total stockholders equity... 36,000 Total liabilities and stockholders equity... $37,200 LUV CARE Statement of Cash Flows For the Month Ended May 31, 2011 Cash flows from operating activities: Cash received from patients... $32,500 Cash paid for expenses... 19,550 Net cash flows from operating activities... $12,950 Cash flows from financing activities: Cash received for capital stock... $20,000 Cash paid for dividends... 3,000 Net cash flows from financing activities... 17,000 Net increase in cash during May... $29,950 Cash as of May 1, 2011... 0 Cash as of May 31, 2011... $29,950 65

E3 4 Net income... $19,000 Add increase in accounts payable... 1,200 Deduct: Increase in prepaid insurance... $(6,600) Increase in supplies... (650) (7,250) Net cash flows from operating activities... $12,950 E3 5 a. Transaction: (a) Issued capital stock in exchange for cash, $20,000 (b) Purchased supplies, on account, for $1,500 (c) Paid cash to creditors for amounts owed, $1,000 (d) Earned fees from cash customers, $22,000 (e) Paid expenses, $13,000 (f) Adjustment for cost of supplies used, $1,100 (g) Earned fees on account, $3,100 (h) Paid dividends, $2,000 b. Net income for August, $11,000 ($22,000 + $3,100 $13,000 $1,100) E3 6 1. (b) Deferred revenue (unearned revenue) 2. (a) Deferred expense (prepaid expense) 3. (b) Deferred revenue (unearned revenue) 4. (d) Accrued revenue (accrued asset) 5. (c) Accrued expense (accrued liability) 6. (a) Deferred expense (prepaid expense) 7. (c) Accrued expense (accrued liability) 8. (c) Accrued expense (accrued liability) 66

E3 7 Account Accounts Receivable... Accumulated Depreciation... Capital stock... Dividends... Interest Payable... Interest Receivable... Land... Office Equipment... Prepaid Rent... Supplies Expense... Unearned Fees... Wages Expense... Answer Normally requires adjustment (AR). Normally requires adjustment (DE). Does not normally require adjustment. Does not normally require adjustment. Normally requires adjustment (AE). Normally requires adjustment (AR). Does not normally require adjustment. Does not normally require adjustment. Normally requires adjustment (DE). Normally requires adjustment (DE). Normally requires adjustment (DR). Normally requires adjustment (AE). E3 8 a. $2,250 ($3,175 $925) b. $2,450 ($600 + $1,850) E3 9 a. Insurance Expense, increase, $10,000 ($10,800 + $7,200 $8,000) Prepaid Insurance, decrease, $10,000 b. Insurance Expense, increase, $12,675 Prepaid Insurance, decrease, $12,675 E3 10 Unearned Fees, decrease, $12,650 Fees Earned, increase, $12,650 ($27,300 $14,650) E3 11 a. Unearned Revenue, decrease, $3,000 million Revenue, increase, $3,000 million b. 22.2% ($13,397 $60,420) 67

E3 12 a. Rent revenue (or revenues) will be understated. Net income will be understated. b. Stockholders equity (retained earnings) at the end of the period will be understated. Unearned rent (or liabilities) will be overstated. E3 13 a. Salary Expense, increase, $2,220 [($3,700/5 days) 3 days] Salaries Payable, increase, $2,220 [($3,700/5 days) 3 days] b. Salary Expense, increase, $2,960 [($3,700/5 days) 4 days] Salaries Payable, increase, $2,960 [($3,700/5 days) 4 days] E3 14 $90,625 ($93,800 $3,175) E3 15 a. Salary expense (or expenses) will be understated. Net income will be overstated. b. Salaries payable (or liabilities) will be understated. Stockholders equity (retained earnings) will be overstated. E3 16 a. Salary expense (or expenses) will be overstated. Net income will be understated. b. The balance sheet will be correct. This is because wages payable has been satisfied, and the net income errors have offset each other. Thus, stockholders equity (retained earnings) is correct. 68

E3 17 a. $1,022,000,000 b. 102.1% ($1,022,000,000 $1,001,000,000) E3 18 Error (a) Error (b) Over- Under- Over- Understated stated stated stated 1. Revenue for the year would be... $ 0 $21,950 $ 0 $ 0 2. Expenses for the year would be... 0 0 0 6,100 3. Net income for the year would be... 0 21,950 6,100 0 4. Assets at July 31 would be... 0 0 0 0 5. Liabilities at July 31 would be... 21,950 0 0 6,100 6. Stockholder s equity at July 31 would be... 0 21,950 6,100 0 E3 19 $440,150 ($424,300 + $21,950 $6,100) E3 20 a. Accounts Receivable, increase, $41,980 Fees Earned, increase, $41,980 b. No. If the cash basis of accounting is used, revenues are recognized only when the cash is received. Therefore, earned but unbilled revenues would not be recognized in the accounts, and no adjusting entry would be necessary. E3 21 a. Unearned Fees, decrease, $85,000 Fees Earned, increase, $85,000 b. Accounts Receivable, increase, $19,200 Fees Earned, increase, $19,200 69

E3 22 a. Fees earned (or revenues) will be understated. Net income will be understated. b. Accounts (fees) receivable (or assets) will be understated. Stockholders equity (retained earnings) will be understated. E3 23 a. Depreciation Expense, increase, $12,700 Accumulated Depreciation, increase, $12,700 b. (1) Depreciation expense would be understated. Net income would be overstated. (2) Accumulated depreciation would be understated, and total assets would be overstated. Stockholders equity (retained earnings) would be overstated. E3 24 Adjustment Account Increase or Decrease Amount 1. Accounts Receivable Increase $8,400 Fees Earned Increase 8,400 2. Supplies Expense Increase 2,100 Supplies Decrease 2,100 3. Insurance Expense Increase 1,800 Prepaid Insurance Decrease 1,800 4. Depreciation Expense Increase 1,500 Accumulated Depreciation Increase 1,500 5. Wages Expense Increase 4,500 Wages Payable Increase 4,500 6. Unearned Rent Decrease 3,000 Rent Revenue Increase 3,000 70

E3 25 a. $824,633,000 ($2,400,685,000 $1,576,052,000) b. No. Depreciation is an allocation method, not a valuation method. That is, depreciation allocates the cost of a fixed asset over its useful life. Depreciation does not attempt to measure market values, which may vary significantly from year to year. E3 26 a. Current asset: 1, 3, 5, 6 b. Property, plant, and equipment: 2, 4 E3 27 Since current liabilities are usually due within one year, $84,000 ($7,000 12 months) would be reported as a current liability on the balance sheet. The remainder of $266,000 ($350,000 $84,000) would be reported as a long-term liability on the balance sheet. 71

E3 28 REHAB HEALTH CO. Balance Sheet June 30, 2010 Assets Current assets: Cash... $ 28,800 Accounts receivable... 35,000 Supplies... 3,000 Prepaid insurance... 11,600 Prepaid rent... 7,200 Total current assets... $ 85,600 Property, plant, and equipment: Equipment... $130,000 Less accumulated depreciation... 33,600 96,400 Total assets... $182,000 Liabilities Current liabilities: Accounts payable... $ 15,200 Salaries payable... 2,800 Unearned fees... 2,000 Total liabilities... $ 20,000 Stockholders Equity Capital stock... $ 50,000 Retained earnings... 112,000 Total stockholders equity... 162,000 Total liabilities and stockholders equity... $182,000 72

E3 29 LA-Z-BOY INC. Balance Sheet April 26, 2008 (in thousands) Assets Current assets: Cash... $ 14,982 Accounts receivable... 200,422 Inventories... 178,361 Other current assets... 33,723 Total current assets... $427,488 Property, plant, and equipment... $438,584 Less accumulated depreciation... 267,583 Total property, plant, and equipment... 171,001 Intangible assets... 56,239 Other long-term assets... 114,142 Total assets... $768,870 Liabilities Current liabilities: Accounts payable... $ 56,421 Accrued expenses... 102,700 Debt due within one year... 4,792 Total current liabilities... $163,913 Long-term liabilities: Long-term debt... $ 99,578 Other long-term liabilities... 54,783 Total long-term liabilities... 154,361 Total liabilities... $318,274 Stockholders Equity Capital stock... $260,816 Retained earnings... 189,780 Total stockholders equity... 450,596 Total liabilities and stockholders equity... $768,870 73

E3 30 1. The date of the statement should be October 31, 2010 and not For the Year Ended October 31, 2010. 2. Accounts payable should be a current liability. 3. Land should be classified as property, plant, and equipment. 4. Accumulated depreciation should be deducted from the related fixed asset. 5. Accounts receivable should be a current asset. 6. Net loss should be reported on the income statement. 7. Wages payable should be a current liability. 8. An adding error was made in determining the amount of the total liabilities and stockholders equity. A corrected balance sheet would be as follows: 74

E3 30, Concluded VINEYARD SERVICES CO. Balance Sheet October 31, 2010 Assets Current assets: Cash... $ 12,000 Accounts receivable... 40,800 Supplies... 4,800 Prepaid insurance... 14,400 Total current assets... $ 72,000 Property, plant, and equipment: Land... $270,000 Building... $225,000 Less accumulated depreciation... 54,600 170,400 Equipment... $ 90,000 Less accumulated depreciation... 32,400 57,600 Total property, plant, and equipment 498,000 Total assets... $570,000 Liabilities Current liabilities: Accounts payable... $ 27,900 Wages payable... 8,100 Total liabilities... $ 36,000 Stockholders Equity Capital stock... $ 90,000 Retained earnings... 444,000 Total stockholders equity... 534,000 Total liabilities and stockholders equity... $570,000 75

PROBLEMS P3 1 Statement of Balance Cash Flows Assets Accts. Prepaid Acc. Cash + Rec. + Insurance + Supplies + Building Dep. + Balances, July 1 20,000 24,500 700 1,000 150,000 11,200 July 1. Received rent rev. 18,000 Balances 38,000 24,500 700 1,000 150,000 11,200 July 1. Paid ins. 4,200 4,200 Balances 33,800 24,500 4,900 1,000 150,000 11,200 July 6. Purchased supplies 1,800 Balances 33,800 24,500 4,900 2,800 150,000 11,200 July 9. Collected cash 17,500 17,500 Balances 51,300 7,000 4,900 2,800 150,000 11,200 July 11. Paid creditors 3,000 Balances 48,300 7,000 4,900 2,800 150,000 11,200 July 18. Issued capital stock 50,000 Balances 98,300 7,000 4,900 2,800 150,000 11,200 July 20. Billed patients 49,000 98,300 56,000 4,900 2,800 150,000 11,200 July 25. Cash fees 12,900 111,200 56,000 4,900 2,800 150,000 11,200 July 30. Paid expenses 37,700 Balances 73,500 56,000 4,900 2,800 150,000 11,200 July 30. Paid dividends 10,000 Balances 63,500 56,000 4,900 2,800 150,000 11,200 Statement of Cash Flows July 1. Operating 18,000 July 1. Operating 4,200 July 9. Operating 17,500 July 11. Operating 3,000 July 18. Financing 50,000 July 25. Operating 12,900 July 30. Operating 37,700 July 30. Financing 10,000 Net increase in cash, July 1 43,500 Beginning cash balance 20,000 Ending cash balance, July 31 63,500 76

P3 1, Concluded Sheet Income = Liabilities + Stockholders Equity Statement Accts. Unearned Wages Notes Capital Retained + Land = Payable + Revenue + Payable + Payable + Stock + Earnings 120,000 7,500 0 0 30,000 40,000 227,500 18,000 120,000 7,500 18,000 0 30,000 40,000 227,500 120,000 7,500 18,000 0 30,000 40,000 227,500 1,800 120,000 9,300 18,000 0 30,000 40,000 227,500 120,000 9,300 18,000 0 30,000 40,000 227,500 3,000 120,000 6,300 18,000 0 30,000 40,000 227,500 50,000 120,000 6,300 18,000 0 30,000 90,000 227,500 49,000 July 20. 120,000 6,300 18,000 0 30,000 90,000 276,500 12,900 July 25. 120,000 6,300 18,000 0 30,000 90,000 289,400 37,700 July 30. 120,000 6,300 18,000 0 30,000 90,000 251,700 10,000 120,000 6,300 18,000 0 30,000 90,000 241,700 Income Statement July 20. Fees earned 49,000 July 25. Fees earned 12,900 July 30. Wages exp. 24,000 Utilities exp. 6,000 Rent exp. 5,000 Interest exp. 200 Misc. exp. 2,500 77

P3 2 Statement of Balance Cash Flows Assets Accts. Prepaid Acc. Cash + Rec. + Insurance + Supplies + Building Dep. + Balances 63,500 56,000 4,900 2,800 150,000 11,200 July 31. Insurance exp. 800 Balances 63,500 56,000 4,100 2,800 150,000 11,200 July 31. Supplies exp. 1,700 Balances 63,500 56,000 4,100 1,100 150,000 11,200 July 31. Dep. exp. 2,000 Balances 63,500 56,000 4,100 1,100 150,000 13,200 July 31. Rental revenue Balances 63,500 56,000 4,100 1,100 150,000 13,200 July 31. Wages exp. Balances 63,500 56,000 4,100 1,100 150,000 13,200 July 31. Fees earned 9,000 Balances, July 31 63,500 65,000 4,100 1,100 150,000 13,200 Statement of Cash Flows July 1. Operating 18,000 July 1. Operating 4,200 July 9. Operating 17,500 July 11. Operating 3,000 July 18. Financing 50,000 July 25. Operating 12,900 July 30. Operating 37,700 July 30. Financing 10,000 Net increase in cash, July 1 43,500 Beginning cash balance 20,000 Ending cash balance, July 31 63,500 78

P3 2, Concluded Sheet Income = Liabilities + Stockholders Equity Statement Accts. Unearned Wages Notes Capital Retained + Land = Payable + Revenue + Payable + Payable + Stock + Earnings 120,000 6,300 18,000 0 30,000 90,000 241,700 800 July 31. 120,000 6,300 18,000 0 30,000 90,000 240,900 1,700 July 31. 120,000 6,300 18,000 0 30,000 90,000 239,200 2,000 July 31. 120,000 6,300 18,000 0 30,000 90,000 237,200 3,000 3,000 July 31. 120,000 6,300 15,000 0 30,000 90,000 240,200 1,700 1,700 July 31. 120,000 6,300 15,000 1,700 30,000 90,000 238,500 9,000 July 31. 120,000 6,300 15,000 1,700 30,000 90,000 247,500 Income Statement July 20. Fees earned 49,000 July 25. Fees earned 12,900 July 30. Wages exp. 24,000 Utilities exp. 6,000 Rent exp. 5,000 Interest exp. 200 Misc. exp. 2,500 July 31. Ins. exp. 800 July 31. Supplies exp. 1,700 July 31. Dep. exp. 2,000 July 31. Rent revenue 3,000 July 31. Wages exp. 1,700 July 31. Fees earned 9,000 Net income 30,000 79

P3 3 1. ESPRESSO HEALTH CARE, INC. Income Statement For the Month Ended July 31, 2011 Fees earned... $ 70,900 Operating expenses: Wages expense... $25,700 Utilities expense... 6,000 Rent expense... 5,000 Depreciation expense... 2,000 Supplies expense... 1,700 Insurance expense... 800 Interest expense... 200 Miscellaneous expense... 2,500 Total operating expenses... 43,900 Operating income... $ 27,000 Other income: Rental revenue... 3,000 Net income... $ 30,000 ESPRESSO HEALTH CARE, INC. Retained Earnings Statement For the Month Ended July 31, 2011 Retained earnings, July 1, 2011... $227,500 Net income for July... $30,000 Less dividends... 10,000 20,000 Retained earnings, July 31, 2011... $247,500 80

P3 3, Concluded ESPRESSO HEALTH CARE, INC. Balance Sheet July 31, 2011 Assets Current assets: Cash... $ 63,500 Accounts receivable... 65,000 Prepaid insurance... 4,100 Supplies... 1,100 Total current assets... $133,700 Property, plant, and equipment: Building... $150,000 Less accumulated depreciation... 13,200 $136,800 Land... 120,000 Total property, plant, and equipment... 256,800 Total assets... $390,500 Liabilities Current liabilities: Accounts payable... $ 6,300 Unearned rent... 15,000 Wages payable... 1,700 Total current liabilities... $ 3,000 Long-term liabilities: Notes payable (due in 2015)... 30,000 Total liabilities... $ 53,000 Stockholders Equity Capital stock... $ 90,000 Retained earnings... 247,500 Total stockholders equity... 337,500 Total liabilities and stockholders equity... $390,500 81

P3 4 1. ESPRESSO HEALTH CARE, INC. Statement of Cash Flows For the Month Ended July 31, 2011 Cash flows from operating activities: Cash received from customers... $ 48,400* Deduct cash payments for expenses... 44,900** Net cash flows from operating activities... $ 3,500 Cash flows from investing activities... 0 Cash flows from financing activities: Cash received from issuance of stock... $ 50,000 Less dividends paid... 10,000 40,000 Net increase in cash... $ 43,500 July 1, 2011, cash balance... 20,000 July 31, 2011, cash balance... $ 63,500 *48,400 = $18,000 + $17,500 + $12,900 **44,900 = $4,200 + $3,000 + $37,700 2. Net income... $ 30,000 Add: Depreciation expense... $ 2,000 Increase in unearned revenue... 15,000 Increase in wages payable... 1,700 18,700 Deduct: Increase in accounts receivable... $(40,500) Increase in supplies... (100) Increase in prepaid insurance... (3,400) Decrease in accounts payable... (1,200) (45,200) Net cash flows from operating activities... $ 3,500 P3 5 Total Net Total Total Stockholders Income Assets Liabilities Equity Reported amounts $135,800 $750,000 $250,000 $500,000 Corrections: Adjustment (a) +6,700 +6,700 0 +6,700 Adjustment (b) 3,000 3,000 0 3,000 Adjustment (c) 2,150 0 +2,150 2,150 Adjustment (d) 1,975 1,975 0 1,975 Corrected amounts $135,375 $751,725 $252,150 $499,575 82

P3 6 1. Statement of Balance Sheet Income Cash Flows Assets = Liabilities + Stockholders Equity Statement Laundry Prepaid Laundry Acc. Accts. Wages Capital Retained Cash + Supplies + Ins. + Equip. Dep. = Payable + Payable + Stock + Earnings Balances, May 31, 2011 169,100 48,000 9,000 6,000 250,000 60,000 7,000 0 50,000 196,000 May 31. (a) 1,800 1,800 (a) May 31. (b) 12,500 12,500 (b) May 31. (c) 7,100 7,100 (c) May 31. (d) 5,500 5,500 (d) Balances, May 31, 2011 48,000 1,900 500 250,000 72,500 7,000 1,800 50,000 Statement of Cash Flows Income Statement Operating (Revenues) 315,000 110,000 30,000 18,000 7,500 1,800 12,500 7,100 5,500 122,600 315,000 May Laundry rev. Financing (Capital Stock) 25,000 May Wages exp. Operating (Expenses) 220,000 May Rent exp. Investing (Equipment) 80,000 May Utilities exp. Financing (Dividends) 5,000 May Misc. exp. Net increase in cash 35,000 May 31. (a) Wages exp. Beginning cash balance, May 31. (b) Depreciation exp. June 1, 2010 13,000 May 31. (c) Supplies exp. Ending cash balance, May 31. (d) Insurance exp. May 31, 2011 48,000 Net income 83

P3 6, Continued 2. MAGNUM THERAPEUTICS, INC. Income Statement For the Year Ended May 31, 2011 Laundry revenue... $315,000 Operating expenses: Wages expense... $111,800 Rent expense... 30,000 Utilities expense... 18,000 Depreciation expense... 12,500 Laundry supplies expense... 7,100 Insurance expense... 5,500 Miscellaneous expense... 7,500 Total operating expenses... 192,400 Net income... $122,600 MAGNUM THERAPEUTICS, INC. Retained Earnings Statement For the Year Ended May 31, 2011 Retained earnings, June 1, 2010... $ 51,500 Net income for the year... $122,600 Less dividends... 5,000 Increase in retained earnings... 117,600 Retained earnings, May 31, 2011... $169,100 84

P3 6, Continued 3. MAGNUM THERAPEUTICS, INC. Balance Sheet May 31, 2011 Assets Current assets: Cash... $ 48,000 Laundry supplies... 1,900 Prepaid insurance... 500 Total current assets... $ 50,400 Property, plant, and equipment: Laundry equipment... $250,000 Less accumulated depreciation... 72,500 177,500 Total assets... $227,900 Liabilities Current liabilities: Accounts payable... $ 7,000 Wages payable... 1,800 Total liabilities... $ 8,800 Stockholders Equity Capital stock... $ 50,000 Retained earnings... 169,100 Total stockholders equity... 219,100 Total liabilities and stockholders equity... $227,900 85

P3 6, Concluded 4. MAGNUM THERAPEUTICS, INC. Statement of Cash Flows For the Year Ended May 31, 2011 Cash flows from operating activities: Cash received from customers... $315,000 Cash paid for expenses... 220,000 Net cash flows from operating activities... $ 95,000 Cash flows from investing activities: Cash paid for equipment... (80,000) Cash flows from financing activities: Cash received for capital stock... $ 25,000 Cash paid for dividends... 5,000 Net cash flows from financing activities... 20,000 Net increase in cash during the year... $ 35,000 Cash as of June 1, 2010... 13,000 Cash as of May 31, 2011... $ 48,000 86

ACTIVITIES A3 1 Revenue is normally recorded when the services are provided or when the goods are delivered (title passes) to the buyer. By waiting until after the services are provided, the expenses of providing the services can be more accurately measured and matched against the related revenues. Also, at this point, the provider of the services has a right to demand payment for the services if payment hasn t already been received. Airlines, such as Delta Air Lines, normally record revenue from ticket sales after completing a flight. At this point, the boarding passes, which have been collected from the passengers, represent revenue to the airline. In addition, the expenses related to each flight, such as landing fees and fuel, would have been incurred and would be accurately measured. Note to Instructors: You might point out to students the following points related to the discussion of the adjusting process in this chapter. (1) The receipt of revenue from customers in advance of a flight represents unearned revenues to the airline. For example, the purchase of discount tickets, which often requires prepayment months in advance of the actual flight, is unearned revenue to the airline. (2) At the end of the airline s accounting period, it would have adjustments related to items such as the following: Accrued wages for employees Depreciation on airplanes, terminal buildings, etc. Unearned revenues (described above) Accrued income from transporting freight, etc. Accrued income from other airlines (When a flight is delayed or canceled, airlines often accept passengers from other airlines and then later collect the revenue from the other airlines.) Prepaid expenses related to insurance, etc. 87

A3 2 1. There are several indications that adjustments were not recorded before the financial statements were prepared, including: a. All expenses on the income statement are identified as paid items and not as expenses. b. No expense is reported on the income statement for depreciation, and no accumulated depreciation is reported on the balance sheet. c. No supplies, accounts payable, or wages payable are reported on the balance sheet. 2. Likely accounts requiring adjustment include: a. Truck (for depreciation) b. Supplies (paid) Expense for supplies on hand c. Insurance (paid) Expense for expired insurance d. Wages Accrued e. Utilities Accrued 88

A3 3 1. The answers will vary among the student groups. The objective of this case is to generate student interest and discussion of business emphases. The advantages of the do-it-yourself emphasis are as follows: a. It requires less capital equipment and training of employees. For example, expensive automotive diagnostic equipment will not have to be purchased and Auto-Mart will not have to train its employees in auto repair and service. That is, it will be easier to staff the stores with sales personnel than with mechanics. b. It emphasizes low costs and has worked well for other companies in the industry, such as AutoZone, Pep Boys, and the automobile departments of Wal-Mart and Kmart. The advantages of the do-it-for-me emphasis are as follows: a. Demographically, the population of the United States is aging. In the future, such demographics mean that more customers will be less willing to fix their own cars. That is, they would rather pay someone to fix their cars for them. b. Increased complexity of cars makes it more difficult for customers to repair their own cars. c. The margins are typically higher for service and maintenance than for retail parts (i.e., service and maintenance are more profitable). d. Kmart recently shut down hundreds of repair and service centers, thus providing an opportunity to offer customers do-it-for-me service. 2. Examples of do-it-yourself include AutoZone, Pep Boys, and Napa Auto Parts in the automotive industry. In the home improvement industry, examples include Home Depot and Lowe s. Examples of do-it-for-me include automotive dealerships and repair and service centers located at Sears and Wal-Mart. Other automotive examples include Mr. Transmission, Midas Muffler, and Brake-O. 89

A3 4 1. CVS Operating income... $6,046,200 Add: Increase in accounts payable... 1,158,400 ($9,792,500 $8,634,100) Deduct: Increase in accounts receivable... (910,500) ($5,819,500 $4,909,000) Adjusted cash basis operating income... $6,294,100 Walgreen Operating income... $3,441,000 Add: Increase in accounts payable... 386,100 ($5,487,000 $5,100,900) Deduct: Increase in accounts receivable... (290,500) ($2,527,000 $2,236,500) Adjusted cash basis operating income... $3,536,600 2. CVS: $247,900 ($6,294,100 $6,046,200) Walgreen: $95,600 ($3,536,600 $3,441,000) 3. CVS: 4.1% ($247,900 $6,046,200) Walgreen: 2.8% ($95,600 $3,441,000) 4. Walgreen s operating income difference of 2.8% is closer to the cash basis than is CVS s income difference of 4.1%. 5. Most analysts focus on operating income rather than net income in assessing the long-term profitability of a company. This is because operating income reflects the basic operating results and business emphasis of the company. In contrast, net income is influenced by other income and expense or income taxes, both of which may be beyond the control of the company and its management. 90

A3 5 1. Company A is Amazon.com Company B is Delta Air Lines Company C is Coca-Cola Inc. Company D is Kroger 2. Coca-Cola Inc. (Company C) is a well-established company that has generally increasing total revenue, operating income, and net income. Coke s net cash flows from operating activities is almost $7.6 billion, which Coke uses to invest in the business and pay off debt and other financing. Delta Air Lines (Company B) is experiencing a dramatic downturn in its profitability and operations because of increasing competition from low-cost airlines and a declining economy. As a result, in 2008 Delta reported an operating loss of $8,314 million and a negative net cash flows from operating activities of $1,707 million. Amazon.com (Company A) has experienced rapidly growing revenues since its inception. Kroger (Company D) has more revenues than does Coca-Cola, but it earns less per revenue dollar. This typifies the grocery industry, where grocery chains like Kroger have large volumes but low margins. For example, consider the 2008 data for Kroger and Coca-Cola. Although Kroger reported $76,000 million of revenue as compared to Coca-Cola s $31,948 million, Kroger reported operating income of only $2,451 million (3.2 cents per revenue dollar) compared to Coca-Cola s operating income of $8,446 million (26.4 cents per revenue dollar). Coke obviously has higher operating margins than does Kroger. This is what we would expect because of Coke s brand name and acceptance of its core products. Like Coke, Kroger has positive net cash flows from operating activities and continues to invest cash in its business. 91