. 22
( 25)



Exhibit 13 Income Balance Sheet Statement of
Statement Cash Flows
The Effect of Period
Costs on the Financial Assets
Statements Cash Paid
Current Assets
Use of Resources in Operating
Operating Activities Expenses
Current Liabilities

For most companies, period expenses result from marketing, research and develop-
ment, and general administrative activities. Marketing costs include the costs of adver-
tising, direct selling and distributing, depreciation of assets used primarily in selling
activities, and the salaries and commissions of the sales force. Research and develop-
ment costs are the costs of creating new products and production processes. Adminis-
trative costs include the depreciation of plant assets used in administrative activities
(office buildings and equipment) and the salaries of managers and office workers.
The costs of certain operating activities are always expensed in the period in which
the activities occur and resources are consumed. For example, GAAP require that re-
search and development costs be expensed when they occur because of uncertainty
about the future benefits to a company of these activities. In most cases, cash is paid
for resources used in operating activities at about the time they are consumed. Ac-
cordingly, companies seldom use long-term debt (bonds or notes payable) to finance
these activities.
The costs of other operating activities are expensed when certain events occur,
which may be long before cash payments are made. As a result, long-term liabilities are
associated with these items. A primary example is deferred compensation. Deferred
compensation results when a company agrees to pay employee retirement benefits.
These benefits are earned by employees as they work for the company. Therefore, the
company recognizes expenses each period as the benefits are earned. Payments may be
deferred for years, however, until benefits are paid to employees after they retire. Con-
sequently, companies often record long-term liabilities associated with these future pay-
ments. The last section of this chapter describes deferred compensation expenses and
liabilities in more detail.
Corporations often report operating expenses on one line on their income state-
ments (see Exhibit 1). Exceptions are made for some items, however. For example,
GAAP require companies to report separately any unusual revenues or expenses that
are material in amount. Separate reporting of these items calls attention to them. Among
these types of items are expenses associated with restructuring a company™s operations.
Restructuring occurs when a company eliminates certain products, closes facilities, re-
duces its labor force, or sells off nonproductive assets. Sears, for example, reported “spe-
cial charges” of $542 million for its fiscal year ended in 2001. These charges were
associated with workforce reductions and facilities consolidations. These items are re-
ported separately because they are not ordinary operating activities. Certain other ex-
penses that are important to a company™s operating activities”research and development
expenses and depreciation expenses, for instance”also must be disclosed, either sepa-
rately on the income statement or in notes to the financial statements. The last section
of this chapter considers other income and expense items that often appear in corpo-
rate financial statements or notes to the statements.
F500 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
504 Activities

Other Revenues and Expenses
Other revenues include interest and other investment income, such as dividends or
gains from the sale of stocks and bonds. Other expenses include interest on short-term
and long-term debt, including interest on capital lease obligations. These amounts are
accrued. The amount of revenue reported is the amount earned, regardless of whether
cash has been received. The amount of expense reported is the amount of obligation
incurred during the current fiscal year, regardless of whether cash has been paid.
As shown in Exhibit 1, Mom™s Cookie Company reported interest expense of
$20,400. Items of this type are not part of the company™s normal operating activities.
Accordingly, they are reported after “operating income” to distinguish them from op-
erating revenues and expenses. These activities are reported as part of the operating ac-
tivities section of the statement of cash flows, however, because they are reported on
the income statement.

Income Taxes
The income statement reports the amount of income taxes that a company would in-
cur if its pretax income were all taxable in the current fiscal year. To determine the in-
come tax expense reported on the income statement, most companies simply multiply
their pretax income times the corporate tax rate. This rate includes federal and state in-
come taxes and is adjusted for foreign taxes for multinational corporations. Conse-
quently, the rate is not the same for all companies. The federal corporate tax rate in the
United States was 35% in 2002. State and foreign tax rates vary.
For many companies, net income is the amount left after income taxes are deducted
from pretax income. For other companies, special items (discussed in the next section)
that affect net income are reported after income taxes.

Non-recurring Gains and Losses
Certain gains and losses are reported separately on a company™s income statement af-
ter the calculation of income associated with normal business activities. These items are
reported separately because they are not expected to recur. The three types of non-
recurring items reported separately are discontinued operations, extraordinary items,
and the cumulative effect of a change in accounting methods.
Discontinued operations are product lines or major parts of a company from
which the company will no longer derive income because it has sold or closed the fa-
cilities that produced the product line or that included that part of the company. Two
types of gains or losses associated with discontinued operations are reported. One is the
gain or loss associated with operations that are being discontinued. Another is the gain
or loss associated with the sale of the discontinued facilities.
For example, assume Beverly Company manufactures boats and sporting equip-
ment. It decides to dispose of its boating division in 2004. On September 30, 2004, the
company sells the division at a loss of $3 million, after taxes. From January 1 to Sep-
tember 30, 2004, the division earned a profit of $1.2 million, after taxes. The company
would report these items separately on its income statement for the fiscal year ended
December 31, 2004, as follows:

Income before taxes $10,000,000
Provision for income taxes (2,600,000)
Income before discontinued operations 7,400,000
Loss on sale of discontinued operations, net of tax
effect of $850,000 (3,000,000)
Operating profit of discontinued operations, net of tax
effect of $420,000 1,200,000
Net income $ 5,600,000
CHAPTER F13: Operating Activities
Operating Activities

Non-recurring items are reported net of the tax effect associated with that item be-
cause if the non-recurring item had not occurred, the associated tax effect would not
have occurred either. Income taxes associated with normal business activities are re-
ported separately as provision for income taxes or income tax expense. The tax effect
usually offsets a reported gain or loss. A gain results in additional taxes. A loss results
in tax savings because the loss can be deducted from other taxable income.
Extraordinary items are gains or losses that are both unusual and infrequent for
a particular company. Losses associated with natural disasters often are reported as ex-
traordinary items. The key to identifying those that are extraordinary is whether or not
the event rarely occurs. For example, damage caused by an earthquake in California
would not be considered an extraordinary loss since earthquakes are not rare in that
area. However, damage caused by an earthquake in Nebraska would be considered ex-
traordinary since that would be a rare event. Like discontinued operations, extraordi-
nary items are reported net of taxes.
A cumulative effect of a change in accounting method is a gain or loss associated
with changing accounting methods or adopting new accounting standards. For ex-
ample, when a company adopts a new standard, it may be required to report expenses
that it was not required to report in the past. When the standard is adopted, the com-
pany estimates the amount of expense that it would have reported in years prior to the
adoption if the new standard had been followed and reports this amount as a cumula-
tive effect of a change in accounting method. Companies are expected to apply ac-
counting methods consistently from one fiscal period to another. Consequently,
companies usually do not change accounting methods once they have adopted them.
Thus, it is relatively uncommon for a company to switch from FIFO to LIFO, for ex-
ample. If a switch is made, the company estimates the difference in expenses it would
have reported in prior years if the alternate method had been used and reports that
amount as a cumulative effect of a change in accounting method.
Net income is the amount earned by a company™s stockholders (both preferred and
common stockholders) during a fiscal period. The amount earned by common stock-
holders is known as net income available for common stockholders and is equal to net
income minus any dividends paid to preferred stockholders. For example, if Harris
Company reported net income of $156,000 and paid $13,000 in preferred dividends in
2004, its net income available for common stockholders would be $143,000 ($156,000
of net income $13,000 of preferred dividends).
When a company reports non-recurring items on its income statement, it also re-
ports earnings per share separately for these items. In addition, earnings per share is
based on income available for common stockholders. If Harris reported an extraordi-
nary loss of $7,000 and had 20,000 shares of common stock outstanding throughout
2004, it would report earnings per share as follows:

Income before extraordinary items $7.50 ($163,000 $13,000) 20,000
Extraordinary loss (net of tax effect of $3,000) (0.35) $7,000 20,000
Net income $7.15 ($156,000 $13,000) 20,000

3 SELF-STUDY PROBLEM King Company, a manufacturer of mattresses, reported the fol-
lowing items on its income statement for 2004.
A. Net operating revenues, $845,000
B. Cost of goods sold, $320,000
C. Selling and administrative expenses, $280,000
D. Research and development expenses, $78,000
E. Net interest expense, $4,000
F. Provision for income taxes, $50,000
G. Current year loss from discontinued operations of $30,000, net of tax benefit of
F502 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
506 Activities

H. Loss from sale of discontinued operations of $100,000, net of tax benefit of $30,000
I. Cumulative effect (gain) of change in accounting principle of $120,000, net of tax
of $40,000
J. Preferred stock dividends, $60,000
The company had 10,000 shares of common stock outstanding throughout the fiscal

Required Compute each of the following:

A. Operating income
B. Income (loss) from continuing operations, before taxes
C. Income (loss) before discontinued operations and the cumulative effect of the ac-
counting change
D. Net income (loss)
E. Net income (loss) available for common shareholders
F. Earnings per share for continuing operations
G. Earnings per share for discontinued operations
H. Earnings per share for the cumulative effect of the accounting change
I. Earnings per share for net income (loss)
The solution to Self-Study Problem 3 appears at the end of the chapter.

This section describes three types of items that may appear on companies™ income state-

Equity Income
Equity income is income that a company earns using the equity method of accounting
for investments in other companies (see Chapter F11). For example, assume that Al-
pha Company owns 40% of Beta Company™s common stock and Beta reports net in-
come of $10 million in 2004. Alpha would report $4 million ($10 million 40%) of
Beta™s income as equity income on its 2004 income statement.

Noncontrolling Interest in Income
As discussed in Chapter F4, consolidated financial statements report the combined ac-
tivities of a parent corporation and its subsidiaries as the operations of one company.
When the parent owns less than 100% of a subsidiary™s common stock, the portion it
does not own is known as noncontrolling (or minority) interest. If Alpha Company
owns 80% (the controlling interest) of Delta Company, the remaining 20% is noncon-
trolling interest. The portion of the subsidiary™s net income attributable to noncon-
trolling interest is reported on the income statement as minority interest in income of
consolidated subsidiaries. This amount is subtracted (assuming positive income) or
added (assuming a loss) in computing net income because it is a portion of subsidiary
income that has not been earned by the parent.
As an example, Krispy Kreme reported the following information on its 2002 in-
come statement (in thousands):

Minority interest $ (1,147)
Income before income taxes 42,546
Provision for income taxes (16,168)
Net income $26,378
CHAPTER F13: Operating Activities
Operating Activities

Deferred Compensation
Some operating expenses are not disclosed separately on the income statement but are
described in detail in notes to the statement. For example, deferred employee com-
pensation expenses are a subject of considerable disclosure by some companies. De-
ferred compensation involves retirement benefits, such as pensions and health-care
benefits, provided to employees once they retire. If companies agree to provide these
benefits, employees earn the benefits over the course of their working careers. The
amount of benefits earned is determined by the wages employees earn and the length
of time they work for a company. Consequently, companies incur expenses for these
future benefits during the working careers of their employees.
To illustrate, assume that Alpha Company determines that the amount of benefits
earned by employees at the end of 2004 is $60 million. This amount is referred to as
the company™s projected benefit obligation. If the fair market value of the assets Alpha
has set aside to meet this obligation is $50 million, the company would report a pen-
sion liability of $10 million.

Projected benefit obligation $60
Fair value of plan assets 50
Pension liability $10

In addition to the liability, Alpha will report an expense associated with benefits
earned by employees during 2004. Assume that benefits earned amounted to $8 mil-
lion and earnings on pension plan assets amounted to $6 million. Alpha would report
a net pension expense of $2 million.

Service cost (benefits earned) $8
Return on plan assets 6
Net pension expense $2

The calculation of deferred compensation costs is complex because it requires es-
timation of future benefits that will be earned by employees after they retire. Thus, a
company must estimate how long employees will work, what amounts they will earn
in the future, and how long they will receive benefits once they retire. The present val-
ues of these amounts then are estimated as a basis for determining the amount of fund-
ing currently required.


1. The income statement reports the results of operating activities on an accrual basis.

2. Revenues result from the sale of goods and services to customers and increase cash
and/or accounts receivable.
a. Revenues should be recognized when all of the following events have occurred:
(1) The seller has completed most activities necessary to produce and sell its prod-
(2) The seller has incurred the costs necessary to produce and sell its products or
can reasonably estimate those costs.
(3) The seller can measure objectively the amount of revenue it has earned.
(4) The seller is reasonably sure of collecting cash from the buyer.
b. Revenues from long-term contracts are recognized each fiscal period in proportion
to the passage of time or the amount of work covered by the contract that has been
c. Sales discounts and returns are deducted from gross revenues in computing the
amount of net revenue reported on the income statement.
F504 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
508 Activities

d. Uncollectible accounts expense is estimated each fiscal year to match the cost of ex-
pected doubtful accounts of customers with the revenues that resulted in the doubt-
ful accounts.
e. Warranty expenses are estimated each fiscal year to match these costs with revenues
that resulted in the costs.

3. Companies purchase inventories, which are recorded as assets and are expensed as cost
of goods sold when the inventory is sold to customers.
a. Merchandise companies account for the purchase and sale of merchandise.
b. Manufacturing companies account for raw materials inventories and for work-in-
process and finished goods inventories, which include the costs of materials, direct
labor, and manufacturing overhead.

4. Most companies estimate inventory and cost of goods sold amounts using one of three
a. First-in, first-out (FIFO) assumes that the units of inventory acquired first are sold
b. Last-in, first-out (LIFO) assumes that the units of inventory acquired most recently
are sold first.
c. Weighted-average uses the average cost of inventory available to determine the cost
of units sold.
d. Perpetual inventory systems, which recognize cost of goods sold as inventory is sold,
are used by most companies. Periodic inventory systems, which determine cost of
goods sold from a count of inventory on hand at the end of a period, are used when
the costs of perpetual systems exceed the benefits of timely inventory information.
e. LIFO is used by many companies that experience increases in inventory costs over
time because it results in lower income taxes and, therefore, higher net operating
cash flow.
f. Companies that use LIFO for determining their income taxes also must use LIFO in
preparing their financial statements.
g. If the market value of inventory at the end of a fiscal period is lower than the cost
of the inventory, the inventory should be written down to market value, regardless
of which inventory estimation method is used.

5. The income statement reports the effects of other operating activities.
a. Operating expenses usually are period costs that reduce cash and/or increase liabili-
b. Some costs, such as research and development, are always expensed in the period in
which they occur.
c. Some activities, such as deferred compensation, are expensed as benefits are earned,
though costs associated with providing the benefits are not incurred until years after
the expenses are recognized.
d. Income taxes are recorded by corporations based on federal, state, and foreign tax

6. Non-recurring items are reported after ordinary income and income taxes on the in-
come statement and are reported net of tax effects.

7. Certain activities often are reported on the income statement or in notes to the finan-
cial statements.
a. Equity income is income a company earns using the equity method of accounting
for investments in other companies.
b. Noncontrolling interest income is the portion of a subsidiary™s net income that is
allocated to noncontrolling interests (owners of the subsidiary other than the parent
c. Deferred compensation arrangements often require a company to recognize a liabil-
ity and expense for benefits earned by employees.
CHAPTER F13: Operating Activities
Operating Activities


cumulative effect of a change in accounting net income available for common stock-
method (F501) holders (F501)
discontinued operations (F500) periodic inventory system (F492)
extraordinary items (F501) perpetual inventory system (F491)
finished goods inventory (F489) raw materials inventory (F489)
first-in, first-out (FIFO) method (F491) weighted-average method (F491)
last-in, first-out (LIFO) method (F491) work-in-process inventory (F489)
lower of cost or market inventory (F497)

Other Contributed Retained
Item Accounts Cash Assets Capital Earnings
1. Merchandise Inventory 400,000
Accounts Payable 400,000
2. Accounts Receivable 750,000
Sales Revenue 750,000
3. Cost of Goods Sold 388,000
Merchandise Inventory 388,000
4. Accounts Payable 384,000
Cash 384,000
5. Cash 720,000
Accounts Receivable 720,000
6. Sales Discounts 17,000
Accounts Receivable 17,000
7. Doubtful Accounts Expense 10,000
Allowance for Doubtful Accounts 10,000
8. Allowance for Doubtful Accounts 8,000
Accounts Receivable 8,000

Income Cash Flow (Direct Method)
Gross sales revenue $750,000 Cash received from customers $720,000
Sales discounts 17,000 Cash paid to suppliers 384,000
Net sales revenue $733,000
Net operating cash flow $336,000
Cost of goods sold 388,000
Doubtful accounts expense 10,000
Cash Flow (Indirect Method)
Net income $335,000
Net income $335,000
Increase in net receivables 3,000
Increase in merchandise 12,000
Increase in accounts payable 16,000
Net operating cash flow $336,000
F506 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
510 Activities

SSP13-2 A.
(In millions) FIFO LIFO
Sales revenue $ 45.00 $ 45.00
Cost of goods sold (28.00) (30.00)
Other expenses (8.00) (8.00)
Pretax income $ 9.00 $ 7.00
Income tax expense (35%) (3.15) (2.45)
Net income $ 5.85 $ 4.55

Fashion Mart™s cost of goods sold would have been $2 million larger using LIFO rather
than FIFO. As a result, its net income would have been $1.3 million ($5.85 $4.55)
less if it had used LIFO. However, it would have incurred $0.7 million ($3.15 $2.45)
less in income taxes if it had used LIFO. Therefore, its net cash flow from operating ac-
tivities would have been $0.7 million greater if it had used LIFO.
B. If Fashion Mart expects the costs of its inventory items to increase over time, LIFO will
result in lower income taxes than FIFO. Therefore, the company will have higher net
operating cash flow using LIFO. On the other hand, if the costs of inventory items are
likely to decrease over time (perhaps because of improved production processes or
greater competition among suppliers), FIFO will result in lower income taxes and
higher net operating cash flow.

SSP13-3 Net operating revenues $845,000
Cost of goods sold (320,000)
Selling and administrative expenses (280,000)
Research and development expenses (78,000)
A. Operating income $167,000
Net interest expense (4,000)
B. Income from continuing operations, before taxes $163,000
Provision for income taxes (50,000)
C. Income before discontinued operations and
cumulative effect of accounting change $113,000
Discontinued operations:
Current period loss, net of tax of $10,000 (30,000)
Loss from sale of discontinued operations, net of
tax of $30,000 (100,000)
Cumulative effect of change in accounting principle,
net of tax of $40,000 120,000
D. Net income $103,000
Preferred dividends (60,000)
E. Net income available for common shareholders $ 43,000
Earnings per share:
F. Continuing operations [($113,000 60,000) 10,000 shares] $ 5.30
G. Discontinued operations ($130,000 10,000 shares) (13.00)
H. Cumulative effect of accounting change
($120,000 10,000 shares) 12.00
I. Net income available for common shareholders
[($103,000 $60,000) 10,000 shares] $ 4.30
CHAPTER F13: Operating Activities
Operating Activities

Thinking Beyond the Question
How do we account for operating activities?

This chapter considered the estimation and reporting of revenues and expenses.
A company™s income statement is affected by estimates of sales returns, doubt-
ful accounts, warranty costs, inventory costs, and similar items. Also, it is af-
fected by whether revenues and expenses require separate reporting and whether
they are associated with recurring or non-recurring activities. Why should stock-
holders and other decision makers care about estimation methods and in which
part of the income statement a company reports its business activities?

If the purpose of the income statement is to report the results of operating activities, why is
there a section on the statement of cash flows that reports the results of operating activities?
Obj. 1

Why is an income statement divided into so many different categories? Couldn™t all the rev-
enues and all the expenses each be totaled and then subtracted from each other to determine
Obj. 1
net income? Wouldn™t this make accounting easier to learn?
A friend tells you, “I just ignore the income statement when I™m making an investment deci-
sion. All I care about is the cash, so that the company can pay me dividends. The balance sheet
Obj. 1
tells me about the cash the company™s got; the cash flows statement tells me about its changes
in cash. Who cares about the income statement? It™s just a bunch of inaccurate stuff loaded
with estimates.” Do you agree with your friend™s statements about the nature of the income
statement and about its lack of importance? Explain why or why not.
When goods are sold FOB shipping point, the buyer usually pays the freight cost. Does this
make sense? Why or why not?
Obj. 2

Sales discounts and sales returns are accounted for as reductions of revenue. If they were ac-
counted for as expenses, wouldn™t the effect on net income be the same? Why not just treat
Obj. 2
sales discounts and sales returns as expenses?
Gross profit results from a company™s transactions with its customers and suppliers. What
types of transactions affect gross profit? How does the accounting for timing differences be-
Obj. 3
tween cash flow and accrual measurements of these transactions affect financial statements?
At a meeting of your manufacturing team, a coworker groans: “We were working so hard to
get the income for our bonus this year. Then they got all that raw material inventory in”and
Obj. 3
even paid for it. We don™t need it yet. Why didn™t they wait until January?” Will the raw ma-
terials inventory affect this year™s income? Does it matter whether it was paid for this year or
in January? Explain your answers.
On December 28, Hadley Company purchased goods FOB destination at a cost of $38,000.
The goods arrived at Hadley™s warehouse and were unloaded on January 5. Hadley™s book-
Obj. 3
keeper is unsure whether these goods should be included in merchandise inventory on the
December 31 balance sheet. Should they? Why or why not?
Q13-9 A friend notes that when a company uses an accounting method such as LIFO, FIFO, or
weighted-average, it is merely estimating (guessing) about the amount of inventory on hand.
Obj. 4
Is this true?
Some corporations use FIFO to estimate their inventory costs. Others use LIFO. What issues
are important to this decision? What effect can the choice have on a company™s net income
Obj. 4
and cash flow from operating activities?
F508 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
512 Activities

Q13-11 When inventory prices are rising, the LIFO method yields lower net income and lower values
for ending inventory than does FIFO. The opposite is true when prices are declining. Why is
Obj. 4
this the case?
GAAP require companies to report inventories on a lower of cost or market basis. What is the
purpose of this measurement rule? What effect does it have on a company™s financial state-
Obj. 4
You are aware that GAAP require expenditures for research and development to be charged
to expense when incurred. This implies that such expenditures do not provide any benefit to
Obj. 5
future accounting periods. Do research and development expenditures have future economic
benefit? If not, why not? If so, why might GAAP require companies to account for them as if
they did not?
Q13-14 You are an investor in the common stock of Malapoosa Company. You notice in the firm™s
most recent annual report that net income was $3.75 million but that the net income avail-
Obj. 5
able for common stockholders was only $3.0 million. Explain the difference between the two
An acquaintance with an interest in investing says, “Earnings per share is so complicated! I
really only want one number”how much the company earned on my investment. But this
Obj. 5
company has earnings per share on income from continuing operations, on a discontinued
segment, and on an extraordinary item, and then, finally, on net income. Which number is
most important to me, as an investor?” Answer your acquaintance.

If your instructor is using Personal Trainer in this course, you may complete online the assign-
EXERCISES ments identified by .
E13-1 Write a short definition of each of the terms listed in the Terms and Concepts Defined in this
Chapter section.

At December 31, 2004, the general ledger of Hoffman Electric had the following account bal-
ances. All adjusting entries (except for income taxes at 35%) have been made. The company
Obj. 1
had 10,400 shares of common stock outstanding during the year.

Accounts payable $ 8,950 Equipment $ 80,300
Accounts receivable 14,970 Gain on sale of land 4,800
Accrued liabilities 21,000 Interest expense 1,420
Accumulated depreciation 15,300 Merchandise 18,465
Advertising expense 9,968 Land 30,000
Cash 9,530 Retained earnings* 57,984
Common stock 36,000 Sales revenue 260,772
Cost of goods sold 102,690 Utilities expense 9,002
Depreciation expense 13,510 Wages expense 59,780
*Balance at January 1, 2004

Prepare an income statement in good form. (Hint: See Exhibit 1.)

An excerpt from the income statement from the 2001 annual report of Alcoa, Inc. is provided
Obj. 1

For the year ended December 31, 2001
(In millions except share amounts)
Sales $22,859
Other income, net 308
CHAPTER F13: Operating Activities
Operating Activities

Costs and expenses
Cost of goods sold 17,857
Selling, general, administrative, and other expenses 1,276
Research and development expenses 203
Provision for depreciation, depletion, and amortization 1,253
Interest expenses 371
Other expenses 566
Income before taxes on income 1,641
Provision for taxes on income 525
Income from operations $ 1,116
Minority interests™ share (208)
Net income $ 908
Earnings per common share $ 1.06

Briefly explain each item presented on the income statement. (Minority interest may be ig-
nored if you are not studying the Other Topics section at the end of the chapter.) How much
gross profit and operating income did Alcoa report for 2001?

San Miguel Company manufactures specialized industrial equipment. The equipment often is
sold under credit terms that provide for payment over a two- or three-year period. A sub-
Obj. 2
stantial prepayment is required before equipment is manufactured. The purchaser accepts ti-
tle to the equipment at the time it is received. San Miguel also sells service contracts on the
equipment it sells. These multiyear contracts stipulate that San Miguel will provide periodic
maintenance on the equipment and will repair the equipment if it breaks down. Explain (a)
when San Miguel should recognize revenue from its equipment sales and (b) when it should
recognize service contract revenue. In each case, explain why this revenue timing is proper.

Goodman Company sold merchandise during its 2004 fiscal year. The total sales price of the
merchandise was $30 million. Because of quantity sales discounts, the company billed its cus-
Obj. 2
tomers $29.1 million for the merchandise. Goodman sells goods to retailers who have a right
to return the merchandise within 90 days if it does not sell. Goodman expects a return rate
of 6% of the amount sold. How much revenue should Goodman recognize for 2004? Justify
your answer.

At year-end 2004, Fenton Company reported gross accounts receivable of $3,650,000 and an
allowance for doubtful accounts of $450,000. During its fiscal 2005 year, it recorded sales of
Obj. 2
$18,600,000 on credit, and collected $18,750,000 from customers. It wrote off $165,000 of bad
debts and estimated that it required an allowance for doubtful accounts at the end of 2005
equal to 3% of its 2005 sales. (a) Use the format presented in this chapter to identify how each
of the year 2005 events would be entered into the accounting system. (b) What was the net
amount of accounts receivable reported by Fenton on its 2005 balance sheet?

For each of the following transactions of Yeats Machinery, indicate in which month or months
the related revenue or expense should appear in the monthly income statement, and why.
Obj. 2

a. In January, the firm receives an order for a $200,000 machine, along with a 30% cash
deposit. The machine is manufactured in March and April, and is delivered to the cus-
tomer on April 16. The remainder of the price is collected in May.
b. Components to be used in manufacturing the above machine are received in February
and paid for in March.
c. Workers are paid for the work on the machine in April and May. Quarterly payments
for their health insurance are made in June. Workers also will receive pension benefits
at some point because of the work they did during this period. (Hint: Health insurance
and pension benefits are part of the cost of labor.)
d. The company estimates there is a 5% chance that it will have to replace parts of the
machine during the two-year warranty period.
F510 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
514 Activities

E13-8 Geyser Company began operations in 2004. It had credit sales of $4 million and cash sales of
$1 million. The chief accountant decided to estimate doubtful accounts expense at 5% of to-
Obj. 2
tal credit sales. During the year, $3.5 million of the credit sales were collected from customers
and by the end of the year, $150,000 had been written off as uncollectible.
At the end of the second year of operations, credit sales were $6 million and cash sales
were $1.5 million. The accountant decided that it would be more accurate to base doubtful
accounts expense on ending Accounts Receivable. Accordingly, it was estimated that the end-
ing balance of Allowance for Doubtful Accounts should have a balance equal to 8% of Ac-
counts Receivable. During the year, $5.4 million was collected from customers and $180,000
was written off as uncollectible.
For each of the two years, determine the following amounts:
a. The ending balance of Accounts Receivable
b. The estimated Doubtful Accounts Expense
c. The ending balance in the Allowance for Doubtful Accounts
During 2004, Abdulla Construction Company started a two-year construction project having
a total contract price of $1,800,000. At December 31, 2004, the firm™s construction engineers
Obj. 2
estimated that the project was 35% completed. To date, 35% of the budgeted $1,250,000 in
costs had been incurred.
What amounts of (a) revenue, (b) expense, and (c) gross profit should be reported by
this company at the end of 2004?
Sandoval, Inc. signed a $40 million contract to build a new office building. The company ex-
pected that the project would take about two and one-half years. During the first year, the
Obj. 2
company incurred the following costs:

Raw materials $4 million
Direct labor 6 million
Overhead (insurance, equipment rental, etc.) 2 million

At the end of the first year, management is very pleased with its construction to date. The
costs incurred are consistent with the estimate that the project is 40% completed.
Determine the amount of (a) revenue and (b) expense that the builder should report on
its income statement at the end of the first year.
E13-11 Boris, Inc. purchased an inventory item for $400 on February 27, 2004, and paid the bill on
March 12. On April 4, Boris sold the item for $625; the customer paid in full on May 15. Use
Objs. 2, 3
the format presented in the chapter to identify how each of these events would affect Boris™s
account balances. What is the net effect of these transactions on Boris™s 2004 income state-
ment? What is the net effect on total assets?
The Nifty Threads Company, a popular clothing store, had the following transactions for 2004.
Objs. 2, 3
1. Nifty Threads purchased $600,000 of clothing from several manufacturers, on credit.
2. The company sold clothing on credit at prices totaling $855,000.
3. The cost of clothing sold to customers was $491,000.
4. The company received a discount of $35,000 on its purchases.
5. The company received $788,000 in cash from customers.
6. The company paid $565,000 to the clothing manufacturers.
7. The company granted $22,000 of sales discounts to customers for payment within the
discount period.
8. The company estimated that $16,000 of the year™s credit sales would be uncollectible.
9. The company wrote off $12,000 as uncollectible.
a. Using the format shown in this chapter, record each of the transactions.
b. Determine the amount of net income and net operating cash flow associated with these
Yeltsin Company purchased a truckload of 1,000 small motors for an invoice price of $50 each
on January 28. Since the company paid the bill within 10 days, on February 6, it received a 2%
Objs. 2, 3
discount. It then sold the parts to Hi-Lo Manufacturing for $65 each on March 27; since Hi-Lo
paid within 10 days, on April 5, it was granted a 1% discount. Calculate the full effect of these
transactions on Yeltsin™s monthly income statements for January, February, March, and April.
CHAPTER F13: Operating Activities
Operating Activities

E13-14 Think carefully about each of the following statements. For each one, indicate whether you
believe it to be always true, generally true, generally false, or always false. For any item you
Objs. 1, 3
judge to fall into the last three categories, describe your reasoning.
a. Sales discounts are reported on the income statement as an operating expense.
b. When a company writes off an uncollectible account against Allowance for Doubtful
Accounts, the net amount of Accounts Receivables reported on the balance sheet does
not change.
c. Jabba Company purchased inventory for its retail store. Jabba should include in the
cost of this inventory the amount charged by the freight company to deliver the goods
to Jabba™s store.
d. Most retail stores will report three categories of inventory: raw materials, work-in-
process, and finished goods.
e. When merchandise is sold to customers, the entries to Sales Revenue and Accounts Re-
ceivable will be for different amounts than the entries to Merchandise and Cost of
Goods Sold.
f. A purchase of merchandise for later resale to customers has no effect on the income
g. Purchase discounts received from vendors should be deducted when determining and
reporting the cost of merchandise.
h. Ford Motor Company just received 1,000 steering wheels for a particular line of cars it
manufactures. The cost of these items should be recorded initially in Work-in-Process
i. The cost of wages earned by factory employees should be reported on the income state-
ment as Wages Expense during the accounting period in which employees earned
j. Diggin Deep Company, a gold mining firm, sold gold bars to Lookin™ Good, Inc. The
second firm is a manufacturer of jewelry. Diggin Deep sold finished goods but Lookin™
Good bought raw materials.
Dickinson Company is a wholesaler of garden supplies. At the beginning of the year, the com-
pany owned 100 bags of Power-Gro lawn fertilizer at a cost of $8 per bag. Before the spring
Obj. 4
gardening season, it purchased its entire supply of Power-Gro for the year, 500 bags at $8.30
each and 400 bags at $8.50 each. During the year, it sold 880 bags for $12 each. (a) Calculate
ending inventory, cost of goods sold, and gross profit under three cost estimating procedures:
periodic FIFO, periodic LIFO, and weighted-average. (b) Which results in the highest gross
profit? The lowest? Why?
InterMetals, Inc. reported ending inventories of $1,687 million at year-end 2004 and $1,911
million at year-end 2005. It used periodic LIFO for most of its inventories. If it had used pe-
Obj. 4
riodic FIFO, it would have reported inventories of $1,948 for 2004 and $2,405 for 2005. As-
suming an income tax rate of 35%, what effect did the use of periodic LIFO instead of periodic
FIFO have on the company™s reported net income and income taxes?
Domestic Company sells kitchen appliances. During the year just ended, the company sold
210,000 units and recorded cost of goods sold totaling $42 million. If periodic LIFO had been
Obj. 4
used, the company would have reported $44 million of cost of goods sold. Inventory to re-
place the units sold was purchased during the year for $45 million. The year-end Accounts
Receivable balance did not differ from the prior year-end. The company™s income tax rate
was 30%. Sales revenue for the year was $60 million and other expenses (all paid in cash)
were $12 million.
a. What would net income have been if Domestic had used periodic LIFO instead of peri-
odic FIFO?
b. What would the company™s cash flow from operating activities have been if it had used
periodic LIFO instead of periodic FIFO?
c. Does the inventory method that results in increased net income also produce increased
operating cash flow? Explain why or why not.
Ten transactions are shown on the next page as they were entered into the accounting system.
For each, explain the event that caused the entry to be made.
Objs. 2, 4

F512 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
516 Activities


Event Accounts Cash Other Assets Liabilities Equity Revenues Expenses
a. Accounts Receivable 50,000
Sales Revenue 50,000
b. Inventory 8,000
Cost of Goods Sold 8,000
c. Cash 2,000
Accounts Receivable 2,000
d. Inventory 35,000
Accounts Payable 35,000
e. Inventory 5,000
Accounts Payable 5,000
f. Doubtful Accounts
Expense 800
Allowance for
Doubtful Accounts 800
g. Accounts Receivable 400
Allowance for
Doubtful Accounts 400
h. Cash 980
Accounts Receivable 1,000
Sales Discounts 20
i. Allowance for Returns 300
Sales Returns 300
j. Warranty Expense 250
Warranty Obligations 250
Totals 2,980 67,900 30,250 49,680 9,050

The following information regarding inventory transactions is available for the month of May.
Obj. 4
Number Unit Total
Date Type of Event of Units Cost Cost
May 1 Beginning inventory 100 $12 $1,200
3 Purchase 50 14 700
12 Sale 70
15 Sale 60
20 Purchase 100 15 1,500
28 Sale 60
Determine the correct balances at May 31 for Merchandise Inventory and Cost of Goods Sold
under each of the following inventory methods: (a) periodic FIFO, (b) periodic LIFO, and
(c) weighted-average.
Small Part Company had the following information regarding inventory transactions avail-
able at the end of October. Year-to-date Cost of Goods Sold at October 1 was $236,700.
Obj. 4

Number Unit Total
Date Type of Event of Units Cost Cost
October 1 Beginning inventory 9,000 $10 $ 90,000
4 Purchase 3,000 12 36,000
11 Sale 8,000
15 Sale 2,000
22 Purchase 10,000 14 140,000
29 Sale 5,000
Determine the correct year-to-date balances at October 31 for Merchandise Inventory and
Cost of Goods Sold under each of the following inventory methods: (a) periodic FIFO, (b)
periodic LIFO, and (c) weighted-average.
CHAPTER F13: Operating Activities
Operating Activities

E13-21 Randolph Company is a retailer that sells appliances to institutions such as schools, universi-
ties, and state governments. During the month of January, Randolph Company recorded the
Obj. 4
following information:
Units Unit Cost Total Cost
January 1 inventory 550 $300 $165,000
Purchases January 5 100 305 30,500
Sales January 7 300
Purchases January 10 600 310 186,000
Sales January 31 500

Assuming Randolph Company uses a perpetual FIFO inventory system, determine the cost of
goods sold and value of the ending inventory.

Using the data provided in E13-21, calculate the cost of goods sold and value of the ending
inventory if Randolph Company uses a perpetual LIFO inventory system.
Obj. 4

A partial income statement is shown below for Mavis Company.
Obj. 5
(In thousands) 2004
Income before extraordinary items and taxes $4,523
Provision for income taxes 1,036
Income before extraordinary items $3,487
Extraordinary loss from condemnation of land for a freeway
(net of tax benefits of $322) 644
Net income $2,843

Earnings per share Basic Diluted
Income before extraordinary items $1.16 $1.00
Extraordinary items 0.21 0.19
Net income $0.95 $0.81

(a) Why are earnings per share presented for both before and after the extraordinary items?
(b) On how many shares was Mavis computing basic earnings per share? Diluted earnings per
share? (c) What kinds of items might account for the additional shares used for the calcula-
tion of diluted earnings per share?

The Hot Aire Company reported the following items on its income statement for 2004.
Obj. 5
a. Net operating revenues, $956,000
b. Cost of goods sold, $312,000
c. Selling and administrative expense, $245,000
d. Research and development expenses, $122,000
e. Net interest expense, $8,500
f. Provision for income taxes, $85,920
g. Current year loss from discontinued operations of $24,000, net of tax benefit of $7,680
h. Loss from sale of discontinued operations of $89,000, net of tax benefit of $24,480
i. Cumulative effect (gain) of change in accounting principle of $11,050, net of tax bene-
fit of $3,536
j. Preferred stock dividends, $48,000
The company had 25,000 shares of common stock outstanding throughout the fiscal year.
Compute each of the following:
A. Operating income
B. Income (loss) from continuing operations, before taxes
C. Income (loss) before discontinued operations and the cumulative effect of the account-
ing change
D. Net income (loss)
E. Net income (loss) available for common shareholders
F. Earnings per share from continuing operations
G. Earnings per share from discontinued operations
H. Earnings per share from the cumulative effect of the accounting change
I. Earnings per share from net income (loss)
F514 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
518 Activities

E13-25 The Oregon Ironworks Company had the following income statement items for the year 2004.
Obj. 5
Income from continuing operations, before taxes $228,000
Current year loss from discontinued operations (10,750)
Gain from sale of discontinued operations 2,750
Extraordinary loss from hurricane (22,500)
Cumulative effect from change of depreciation method 6,000
Tax rate, applicable to all income statement items 30%
Number of shares of common stock outstanding during 2004 79,800

a. Beginning with “Income from continuing operations, before taxes,” prepare the re-
maining sections of the income statement.
b. Calculate earnings per common share for all sections of the income statement. The
company has no preferred stock outstanding. (Note: The information about special
items should be listed in the following order: discontinued operations, extraordinary
items, changes in accounting method.)
Explain whether each of the following would be expensed on the income statement in 2004
or in some later year, and why.
Objs. 2, 3, 5

a. Inventory purchased in 2004 but sold in 2005.
b. Estimated warranty costs for goods sold in 2004; the warranty servicing will take place
in 2005 and 2006.
c. Bad debts caused by 2004 sales; the actual bad receivables will not be identified until a
later year.
d. Research and development costs incurred in 2004 but aimed at producing a better
product in later years.

If your instructor is using Personal Trainer in this course, you may complete online the assign-
PROBLEMS ments identified by .

Income Statement Preparation
Obj. 1 On January 1, 2004, Pete Rabbit began Leafy Green Corporation, a salad bar supply business,
by investing $5,000 cash and a delivery van worth $7,200 in exchange for 1,000 shares of $2
par common stock. Pete expects the van to have a remaining life of three years with no sal-
vage value; he plans to use straight-line depreciation. Two friends invested $2,000 each, re-
ceiving 150 shares of stock each.
The next day, Leafy Green borrowed $8,400 at 8% annual interest for operating funds.
The loan is to be repaid or refinanced in three months.
Salad ingredients for the month of January cost $8,000; Leafy Green has paid for 75% of
this. The company has delivered prepared salad bar materials to three customers, each of whom
has been billed $5,000; two of the three have paid. No ingredients were on hand at the end of
the month.
Other operating expenses, paid in cash, were $4,500.

Required Prepare an income statement for Leafy Green Corporation, for the month of Jan-
uary 2004. Include earnings per share.

Revenue Recognition
Obj. 2 Several situations in which the timing of revenue is in doubt are listed below.
a. An appliance manufacturer sent out a truckload of dishwashers FOB destination in late
January; they arrived February 2 and were paid for in March. Monthly income state-
ments are prepared.
b. A magazine publisher sold two-year subscriptions for a monthly publication.
c. An auto dealer sold five-year service contracts for cash at the time of the auto sale.
d. A home decorating center sold wallpaper with a 60-day right to return of up to 25% of
an order. For the past several years, returns have been fairly consistent, with one in 10
customers returning some paper; the average return is 1.2 rolls.
CHAPTER F13: Operating Activities
Operating Activities

e. A bridge construction firm is involved in only one project at a time; the average project
takes three years. The contract price is firm and definitely collectible; total costs of the
project can be estimated.

Required First, explain what events generally must occur before any revenue is recognized.
Then discuss when each of the above situations should result in revenue recognition, and why.

Revenue Recognition
Obj. 2 The following excerpt is from Unisys Corporation™s 2001 annual report.
Revenue Recognition. Revenue from hardware sales is recognized upon shipment and
the passage of title.¦Revenue from software licenses is recognized at the inception of
the initial license term and upon execution of an extension to the license term.¦Rev-
enue from equipment and software maintenance is recognized on a straight-line basis
as earned over the lives of the respective contracts.¦For contracts accounted for on the
percentage-of-completion basis, revenue and profit recognized in any given accounting
period is based on estimates of total projected contract costs, the estimates are contin-
ually reevaluated and revised, when necessary, throughout the life of a contract.

Required What is meant by revenue recognition? Why does Unisys use different revenue
recognition principles for different types of revenue? What are the critical events for each of
these types of revenue? Why is estimation involved in revenue recognition for the multiyear,
fixed-price contracts?

Computing Accounts Receivable
Obj. 2 Georgia Company reported accounts receivable of $16.5 million at the end of its 2004 fiscal
year. This amount was net of an allowance for doubtful accounts of $1,800,000. During 2005,
Georgia sold $56.5 million of merchandise on credit. It collected $57.9 million from customers.
Accounts valued at $1,980,000 were written off as uncollectible during 2005. Georgia™s man-
agement estimates that 10% of the year-end Accounts Receivable balance will be uncollectible.

Required Answer each of the following questions:
A. What amount will Georgia report for accounts receivable and the allowance for doubt-
ful accounts at the end of 2005?
B. What is the Doubtful Accounts Expense for 2005?
C. How will the accounts receivable and allowance accounts be presented on the balance
sheet? Show the balance sheet.
D. Why do companies record expenses for doubtful accounts based on estimates from re-
ceivables or sales during the prior year rather than recording the expenses when ac-
counts are written off in a future period?
E. If estimated uncollectibles as a percentage of sales or receivables were to increase over
several years, what information might this provide to decision makers?

Inventory Transactions of Manufacturing Companies
Obj. 3 O™Neill Company began the year with $870,000 of raw materials inventory, $1,390,000 of work-
in-process inventory, and $620,000 of finished goods inventory. During the year, the com-
pany purchased $3,550,000 of raw material and used $3,720,000 of raw materials in production.
Labor used in production for the year was $2,490,000. Overhead was $1,380,000. Cost of goods
sold for the year was $7,500,000. The ending balance of Finished Goods Inventory was

Required Use Exhibit 5 in the chapter as a format for developing a schedule to show the ef-
fect of these events on O™Neill™s inventory accounts for the year.

Classification of Manufacturing Costs
Obj. 3 The following information is taken from the records of the Carolby Company, a manufac-
turer of lawn furniture. Indicate whether the cost of each item should be included as part of
F516 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
520 Activities

the finished goods cost or should be treated as an expense. For the items that become part of
the cost of finished goods, indicate whether each should be designated as materials, labor, or
factory overhead.
a. Salaries of sales office staff
b. Electric utilities for the factory area
c. Office supplies
d. Paint and miscellaneous plastic parts
e. Depreciation on factory equipment
f. Depreciation on delivery vans
g. Salaries of factory foremen
h. Miscellaneous factory supplies
i. Steel rods used for chair frames
j. Plastic sheets used for table tops
k. Salaries of furniture assemblers
l. Insurance on the factory
m. Insurance on the administrative offices
n. Advertising in trade magazines
o. Lawn furniture sold to retailers
p. Rental of storage facilities for materials
q. Rental of storage facilities for finished goods
Required Briefly explain your reasoning for classifying the various items as part of the cost
of goods manufactured or as an expense.

Objs. 3, 4 Modern Industries manufactures a variety of computer parts and accessories in a rapidly chang-
ing technological environment. At year-end 2004, it reported the following comparative in-
formation regarding inventories.
(In millions) 2004 2003
Raw materials and parts $14 $16
Work in process 28 31
Finished goods 25 28
Total inventories $67 $75

The 2004 income statement reflected cost of sales of $3,165 million. In the operating activi-
ties section of the statement of cash flows, the $8 million decrease in inventories was added
to net income. Notes to the financial statements included the following:
• Inventories are reported at the lower of cost (first-in, first-out) or market. If the cost of
the inventories exceeds their market (replacement) value, a writedown to market value is
taken currently.
• The company participates in a highly competitive industry that is characterized by rapid
changes in technology, frequent introductions of new products, short product life cycles,
and downward pressures on prices and margins.
Required Answer the following questions related to Modern Industries™ inventories.
A. Describe the nature of each of the three inventories listed on the balance sheet. When
does each become an expense?
B. Why is the inventory decrease added to net income on the statement of cash flows?
C. Many U.S. corporations use the LIFO inventory method to save income taxes. Why might
a computer industry manufacturer like this firm decide to use FIFO instead? Explain.

Inventory Transactions and Periodic Inventory Costing Methods
Objs. 3, 4 Culture Music Store had the following selected account balances on October 1.
Merchandise inventory (1,000 units) $ 7,000
Accounts receivable 15,000
Allowance for doubtful accounts (1,200)
Warranty obligations 500
CHAPTER F13: Operating Activities
Operating Activities

Goods are sold with a 60-day money-back guarantee against defects. During October, the fol-
lowing transactions occurred.
1. The store purchased 4,000 units of inventory on credit at a total invoice cost of
$32,000. The goods, which were received in October, were purchased FOB destination
and the seller paid freight costs of $250.
2. During the first week of the month, 700 units were sold on credit at prices averaging
$12 each.
3. A clerk noticed that 50 recordings purchased in part 1 were mislabeled. These units
were returned to the vendor for full credit.
4. During the second week, a cash-only sale was held and 1,200 units sold at an average
price of $10 each.
5. Customers returned a total of 53 units that had been sold in part 2. The goods were in
salable condition and returned to the shelf.
6. The vendor was paid in full for the goods purchased in part 1.
7. Checks were received from customers who purchased goods in part 2. All took the 2%
discount that was offered for paying within 10 days.
8. A total of 1,600 units were sold during the rest of the month at prices averaging $13.
Three-quarters of the sales were on credit.
9. At month-end, management estimated that 10% of the goods sold in parts 4 and 8
would be returned as defective.
10. Also at month-end, management estimated that $344 of this period™s credit sales would
be uncollectible.

A. Show how each of the transactions would be entered into the accounting system as-
suming the firm uses the periodic FIFO inventory method.
B. Prepare an income statement for the month of October assuming that operating ex-
penses (other than warranty expense and doubtful accounts expense) totaled $2,500
and the company™s tax rate is 35%.
C. By what amount would net income have been different if the periodic LIFO method
had been used? Prepare a schedule that proves your solution.
D. By what amount would net cash flow from operating activities have been different if
the periodic LIFO method has been used? Explain your solution.

Accounting Errors Regarding Operating Activities
Objs. 3, 4 At year-end, the accounting department at Bell-Jones Industries had prepared the following
balance sheet and income statement.

Balance sheet Income statement

Cash $ 58,000 Net sales $ 1,855,000
Accounts receivable 215,000 Service contracts 792,000
Less: Allowance for returns 9,000 Cost of goods sold (1,298,500)
Allowance for doubtful accounts (3,000) Operating expenses:
Merchandise 136,000 Wages (537,300)
Buildings and equipment 413,000 Rent (60,000)
Less: Accumulated depreciation (107,800) Advertising (282,000)
Land 79,000 Doubtful accounts 0
Total assets $ 799,200 Depreciation (26,800)
Warranties (55,000)
Accounts payable $ 108,200 Operating income $ 387,400
Wages payable 25,000 Interest revenue 1,350
Warranty obligations 61,000 Income before taxes 388,750
Common stock 300,000 Provision for taxes 136,063
Retained earnings 305,000 Net income $ 252,687
Total liabilities and stockholders™ equity $ 799,200
F518 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
522 Activities

Just prior to the arrival of the outside auditors, one of the accounting staff brought a list of
items to the chief financial officer. The staff member was concerned that these items had not
been properly accounted for in the financial statements.
1. A source document showing a customer™s return of goods had been missing until just
now and had not been processed through the accounting system. The goods had been
sold on account to the customer for $9,000 during the current year and were returned
to the warehouse for sale to others. The company™s normal gross profit on sales is 30%.
2. Just before year-end, inventory had been purchased on credit at a cost of $60,000, FOB
destination. By year-end, it had not yet arrived but it had been included in the ending
inventory anyway.
3. At the end of the prior year, there was $80,000 of inventory in transit from a supplier.
The goods had been purchased FOB shipping point but had not yet arrived. The goods
had been included in last year™s ending inventory anyway.
4. An error had been made in computing the warranty costs for goods sold during the
current year. A total of $55,000 had been charged to Warranty Expense, but the correct
amount was $75,000.
5. Near year-end, a $100,000 service contract was obtained from a major customer. It was
a renewal of an existing contract that would otherwise have expired during the coming
year. Because this type of work had been performed many times before for this cus-
tomer, the contract was entered into the accounting system as a credit sale during the
year just ended. Collection of the cash will occur as the services are performed.
6. The adjusting entry to allowance for returns had not yet been recorded at year-end. Us-
ing the firm™s usual approach, an additional $10,300 should be recorded.
7. No adjusting entry had been made at year-end to account for doubtful accounts. Using
the firm™s usual approach, $5,960 should be charged to expense.

A. Show any entries to the accounting system that you believe should be made as a result
of this information. If an item does not require an entry, explain why.
B. What is the proper amount of operating income that should be reported for the pe-
riod? Prepare a schedule to show how you determined this amount.

Identifying Perpetual Inventory Costing Methods
Objs. 3, 4 At the end of the first quarter, yesterday, a staff accountant prepared the information below.
It is a schedule of merchandise inventory and cost of goods sold under each of the three most
common costing methods: perpetual LIFO, perpetual FIFO, and perpetual weighted-average.
Unfortunately, she forgot to label which one was which and today is her day off.

Schedule of merchandise inventory and cost of goods sold

Summary of inventory transactions:
Beginning inventory: March 1 9,000 units at $10 each
Purchases: March 3 3,000 units at $12 each
March 24 10,000 units at $14 each
Sales: March 11 7,000 units at $15
March 15 2,000 units at $15
March 30 4,000 units at $17

Costing results using method A: Merchandise Inventory Cost of Goods Sold
March 1 beginning balances $ 90,000 $236,700
March 3 purchase 36,000 ”
March 11 sale 73,500 73,500
March 15 sale 21,000 21,000
March 24 purchase 140,000 ”
March 30 sale 52,760 52,760
March 31 ending balances $118,740 $383,960
CHAPTER F13: Operating Activities
Operating Activities

Costing results using method B: Merchandise Inventory Cost of Goods Sold
March 1 beginning balances $ 90,000 $236,700
March 3 purchase 36,000 ”
March 11 sale 70,000 70,000
March 15 sale 20,000 20,000
March 24 purchase 140,000 ”
March 30 sale 50,000 50,000
March 31 ending balances $126,000 $376,700

Costing results using method C: Merchandise Inventory Cost of Goods Sold
March 1 beginning balances $ 90,000 $236,700
March 3 purchase 36,000 ”
March 11 sale 76,000 76,000
March 15 sale 20,000 20,000
March 24 purchase 140,000 ”
March 30 sale 56,000 56,000
March 31 ending balances $114,000 $388,700

A. Match each set of cost results above with the inventory costing method used to gener-
ate it. (Hint: In which direction are prices moving?)
B. Prove your results by showing how the amount for the first sale was computed under
each method.

Periodic Inventory Estimation and Income Control
Obj. 4 Rousseau Company uses the periodic LIFO inventory estimation method. At the beginning of
the current fiscal year, the company™s inventory consisted of the following:

Units Unit Cost Total Cost
8,000 $22 $176,000
4,000 23 92,000
2,000 32 64,000
2,000 34 68,000
16,000 $400,000

These units were produced over several years, during which inventory costs had increased
rapidly. During the current year, Rousseau produced 20,000 additional units of inventory at
an average cost of $36 per unit. The average sales price of units sold during the year was $55.

Required Answer the following questions.
A. What would be Rousseau™s gross profit and average gross profit per unit if it sold
20,000, 24,000, 28,000, or 36,000 units during the year?
B. Assume that Rousseau sold 36,000 units during the year. How many units would it
need to produce to minimize the tax effect of its gross profit? How many units would it
need to produce to maximize its gross profit?
C. If you were a manager of Rousseau and you wanted to control the amount of gross
profit reported by the company, what could you do? If you wanted to develop an ac-
counting standard that could prevent this type of management manipulation of in-
come, what kind of standard might you propose?

Accounting Choice Decisions
Obj. 4 Shim Company reported sales revenue of $10 million for the year. The company uses FIFO
for inventory estimation purposes. Cost of goods sold was $3.8 million. If the company had
used LIFO, its cost of goods sold would have been $4.5 million. The company reported de-
preciation expense of $1.2 million on a straight-line basis. If the company had used acceler-
F520 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
524 Activities

ated depreciation, it would have reported depreciation expense of $1.7 million. Other expenses,
excluding income tax, were $3 million. The company™s income tax rate was 30%.

A. Compute Shim™s net income as reported and as it would have been reported if LIFO
and accelerated depreciation had been used.
B. What effect would the choice of accounting methods have on the company™s cash flows
from operating activities during the year if the same methods were used for both finan-
cial reporting and tax purposes?

Perpetual and Periodic Inventory Systems
Obj. 4 Records of the Genesis Corporation reveal the following information about inventory during
the year.

January 1 Beginning inventory 1,000 units @ $10
March 15 Purchase of inventory 3,500 units @ $12
July 21 Sale of inventory 4,000 units
September 12 Purchase of inventory 1,600 units @ $14
October 31 Sale of inventory 1,200 units

The company™s accountant is trying to decide whether to determine Cost of Goods Sold us-
ing the perpetual inventory system (calculating Cost of Goods Sold after every sale) or the pe-
riodic inventory system (calculating Cost of Goods Sold at the end of the year only). Assume
the company uses the LIFO method for inventory costing.

Required Using the information given above, answer each of the following questions.
A. How many units have been sold? How many units remain in ending inventory?
B. What is Cost of Goods Sold using the perpetual method? The periodic method? What
is the cost of ending inventory for each method?
C. Is there a difference in net income for each method? Why? (Assume for purposes of
this question that Sales Revenue is $85,000 and all other expenses are $5,600.)
D. What are the advantages of using perpetual? Using periodic?

P13-14 Preparing an Income Statement
Objs. 1, 5
Shriver Company™s accounting system listed the following information for the company™s 2004
fiscal year (in millions):

Average common shares outstanding 2.4
Cost of goods sold $170.3
Extraordinary gain 18.2
Gain on sale of securities 8.6
General and administrative expenses 75.5
Income taxes (35% of pretax income)
Interest expense 12.0
Interest income 5.9
Loss associated with cumulative effect of accounting change 4.0
Loss from discontinued operations 13.1
Sales of merchandise 320.8
Selling expenses 30.2

Required Prepare an income statement for Shriver Company for the year ended December
31, 2004. Assume that the tax rate of 35% applies to special items as well as ordinary income.
(Hint: Discontinued operations are listed before extraordinary items, which are listed before
accounting changes.)
CHAPTER F13: Operating Activities
Operating Activities

P13-15 Interpreting an Income Statement
Objs. 1, 5
Worldwide Corporation reported the following income statement for 2005.

(In millions) 2005 2004 2003
Product sales $ 3,355 $ 3,298 $ 3,236
Service sales 2,941 2,591 2,543
Sales of products and services 6,296 5,889 5,779
Cost of products sold (2,549) (2,523) (2,508)
Cost of services sold (1,931) (1,754) (1,743)
Costs of products and services sold (4,480) (4,277) (4,251)
Provision for restructuring (86) (23) (249)
Marketing, administration, and general expenses (1,686) (1,184) (1,313)
Other income and expenses, net 149 (288) (154)
Interest expense (233) (134) (165)
Loss from continuing operations before
income taxes and minority interest
in income of consolidated subsidiaries (40) (17) (353)
Income taxes 7 13 116
Minority interest in income of consolidated subsidiaries (11) (9) (9)
Loss from continuing operations (44) (13) (246)
Discontinued operations, net of income taxes:
Income from operations 135 90 71
Estimated loss on disposal of discontinued operations (76) (95)
Income (loss) from discontinued operations 59 90 (24)
Income (loss) before cumulative effect of change in
accounting principle 15 77 (270)
Cumulative effect of change in accounting principle
Postemployment benefits (56)
Net income (loss) $ 15 $ 77 $ (326)

Required Answer each of the following questions.
A. For 2005, calculate the gross profit on product sales and on service sales. Why are these
shown separately?
B. What is a “provision for restructuring”? What is a “discontinued segment”? Why is it
that the restructuring provision is part of operating income, but the discontinued seg-
ment is not?
C. Some businesses show interest expense in a separate section with a title like “Other
Revenues and Expenses,” below Income from Operations. Would Worldwide™s operat-
ing income have been positive in the years presented if it did not include interest ex-
D. Why is “income taxes” a positive number, not an expense?
E. What is a “cumulative effect of change in accounting principle”?
F. Which would be of more use in attempting to predict the financial future of the com-
pany: income from continuing operations or the final net income numbers, including
the discontinued operations and the effect of the change in accounting principle?
G. Why are the effects of the discontinued segment and the change in accounting princi-
ple presented net of any tax effect?

Presentation of the Income Statement
Objs. 1, 5 Pelican Enterprises had the following account balances in its general ledger at June 30, 2004,
the end of the company™s fiscal year. All adjusting entries (except for the accrual of income
taxes at 30%) had been entered. The company had an average of 900,000 shares of common
stock outstanding during the year.
F522 OperatingSECTION F2: Analysis and Interpretation of Financial Accounting Information
526 Activities

General ledger account balances (in thousands)
Accounts receivable $ 349 Land $1,980
Accumulated depreciation 922 Loss on sale of old machinery 255
Advertising expense 1,224 Merchandise inventory 471
Buildings and equipment 4,811 Notes payable, long-term 150
Cash 482 Preferred stock, 7% 300
Common stock 2,400 Prepaid advertising 54
Cost of goods sold 3,660 Rent expense 546
Depreciation expense 102 Rent payable 450
Extraordinary gain on Retained earnings 513
extinguishment of debt 40 Sales revenue 6,930
Investments, long-term 250 Service revenue 3,382
Interest revenue 44 Wages expense 855
Interest expense 124 Wages payable 32

A. Prepare an income statement in good form, including earnings per share information.
B. Have the closing entries been made to the accounting system? How can you tell? (Hint:
You might want to review the accounting cycle in Chapter F3.)
C. What is the amount of net income available to common stockholders? Why is this im-
portant information?
D. Why do you think that GAAP require that gross profit, operating income, pretax in-
come, and net income be separately disclosed?


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