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EXERCISE 6-15 COMPARING THE PERCENTAGE OF SALES AND THE
PERCENTAGE OF RECEIVABLES METHODS
Keefer Company uses the percentage of sales method for computing bad debt expense. As of
January 1, 2003, the balance of Allowance for Bad Debts was $200,000. Write-offs of uncol-
lectible accounts during 2003 totaled $240,000. Reported bad debt expense for 2003 was
$320,000, computed using the percentage of sales method.
Keith & Harding, the auditors of Keefer s financial statements, compiled an aging ac-
counts receivable analysis of Keefer s accounts at the end of 2003. This analysis has led Keith
& Harding to estimate that, of the accounts receivable Keefer has as of the end of 2003,
$700,000 will ultimately prove to be uncollectible.
Given their analysis, Keith & Harding, the auditors, think that Keefer should make an
adjustment to its 2003 financial statements. What adjusting journal entry should Keith &
Harding suggest?

EXERCISE 6-16 RATIO ANALYSIS
The following are summary financial data for Parker Enterprises, Inc., and Boulder, Inc., for
three recent years:

Year 3 Year 2 Year 1

Net sales (in millions):
Parker Enterprises, Inc. . . . . . . . . . . . . . . . . . . . . . . $ 3,700 $ 3,875 $ 3,882
Boulder, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,825 16,549 15,242
Net accounts receivable (in millions):
Parker Enterprises, Inc. . . . . . . . . . . . . . . . . . . . . . . 1,400 1,800 1,725
Boulder, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,525 5,800 6,205
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1. Using the above data, compute the accounts receivable turnover and average collection
period for each company for years 2 and 3.
2. Which company appears to have the better credit management policy?

EXERCISE 6-17 ASSESSING HOW WELL COMPANIES MANAGE THEIR
RECEIVABLES
Assume that Hickory Company has the following data related to its accounts receivable:

2002 2003

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,425,000 $1,650,000
Net receivables:
Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000 333,500
End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 375,000


Use these data to compute accounts receivable turnover ratios and average collection peri-
ods for 2002 and 2003. Based on your analysis, is Hickory Company managing its receivables
better or worse in 2003 than it did in 2002?

EXERCISE 6-18 MEASURING ACCOUNTS RECEIVABLE QUALITY
The following accounts receivable information is for Happy Tiny Company:

2003 2002 2001

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . $300,000 $260,000 $220,000
Allowance for bad debts . . . . . . . . . . . . . . . . . . 18,000 17,000 16,000


Did the creditworthiness of Happy Tiny s customers increase or decrease between 2001 and
2003? Explain.

EXERCISE 6-19 ACCOUNTING FOR WARRANTIES
Rick Procter, president of Sharp Television Stores, has been concerned recently about declin-
ing sales due to increased competition in the area. Rick has noticed that many of the national
stores selling television sets and appliances have been placing heavy emphasis on warranties in
their marketing programs. In an effort to revitalize sales, Rick has decided to offer free service
and repairs for one year as a warranty on his television sets. Based on experience, Rick believes
that first-year service and repair costs on the television sets will be approximately 5% of sales.
The first month of operations following the initiation of Rick s new marketing plan showed
significant increases in sales of TV sets. Total sales of TV sets for the first three months under
the warranty plan were $10,000, $8,000, and $12,000, respectively.
1. Assuming that Rick prepares adjusting entries and financial statements for his own use at
the end of each month, prepare the appropriate entry to recognize customer service (war-
ranty) expense for each of these first three months.
2. Prepare the appropriate entry to record services provided to repair sets under warranty in
the second month, assuming that the following costs were incurred: labor (paid in cash),
$550; supplies, $330.

EXERCISE 6-20 ACCOUNTING FOR WARRANTIES
Johnson Auto sells used cars and trucks. During 2003, it sold 51 cars and trucks for a total of
$1,350,000. Johnson provides a 12-month, 12,000-mile warranty on the used cars and trucks
sold. Johnson estimates that it will cost $25,000 in labor and $13,000 in parts to service
(during the following year) the cars and trucks sold in 2003.
In January 2004, Steve Martin brought his truck in for warranty repairs. Johnson Auto
fixed the truck under its warranty agreement. It cost Johnson $400 in labor and $275 in parts
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to fix Steve Martin s truck. Prepare the journal entries to record (1) Johnson Auto s estimated
customer service liability as of December 31, 2003, and (2) the costs incurred in repairing the
truck in January 2004.




EXERCISE 6-21 PREPARING A BANK RECONCILIATION
Prepare a bank reconciliation for Oldroyd Company at January 31, 2003, using the informa-
tion shown.
1. Cash per the accounting records at January 31 amounted to $72,802; the bank statement
on this same date showed a balance of $64,502.
2. The canceled checks returned by the bank included a check written by the Oldham
Company for $1,764 that had been deducted from Oldroyd s account in error.
3. Deposits in transit as of January 31, 2003, amounted to $10,928.
4. The following amounts were adjustments to Oldroyd Company s account on the bank
statement:
a. Service charges of $26.
b. An NSF check of $1,400.
c. Interest earned on the account, $40.
5. Checks written by Oldroyd Company that have not yet cleared the bank include four
checks totaling $5,778.


EXERCISE 6-22 PREPARING A BANK RECONCILIATION
The records of Denna Corporation show the following bank statement information for De-
cember:
a. Bank balance, December 31, 2003, $87,450
b. Service charges for December, $50
c. Rent collected by bank, $1,000
d. Note receivable collected by bank (including $300 interest), $2,300
e. December check returned marked NSF (check was a payment of an account receivable),
$200
f. Bank erroneously reduced Denna s account for a check written by Dunna Company,
$1,000
g. Cash account balance, December 31, 2003, $81,200
h. Outstanding checks, $9,200
i. Deposits in transit, $5,000
1. Prepare a bank reconciliation for December.
2. Prepare the entry to correct the cash account as of December 31, 2003.


EXERCISE 6-23 RECONCILING BOOK AND BANK BALANCES
Jensen Company has just received the September 30, 2003, bank statement summarized in
the following schedule:

Charges Deposits Balance

Balance, September 1 . . . . . . . . . . . . . . . . . . . . . $ 5,100
Deposits recorded during September . . . . . . . . . $27,000 32,100
Checks cleared during September . . . . . . . . . . . . $27,300 4,800
NSF check, J. J. Jones . . . . . . . . . . . . . . . . . . . . 50 4,750
Bank service charges . . . . . . . . . . . . . . . . . . . . . 10 4,740
Balance, September 30 . . . . . . . . . . . . . . . . . . . . 4,740
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Cash on hand (recorded on Jensen s books but not deposited) on September 1 and September
30 amounted to $200. There were no deposits in transit or checks outstanding at September
1, 2003. The cash account for September reflected the following:

Cash

Sept. 1 Balance 5,300 Sept. Checks 28,000
Sept. Deposits 29,500

Answer the following questions. (Hint: It may be helpful to prepare a complete bank reconcil-
iation.)
1. What is the ending balance per the cash account before adjustments?
2. What adjustments should be added to the depositor s books?
3. What is the total amount of the deductions from the depositor s books?
4. What is the total amount to be added to the bank s balance?
5. What is the total amount to be deducted from the bank s balance?

EXERCISE 6-24 JOURNAL ENTRIES FOR NOTES RECEIVABLE
Prepare journal entries for the following transactions for Stansworth Plumbing for 2003:
July 1 Installed a sprinkling system for Chuck s Engineering and billed $12,600 for the job.
Sept. 1 Chuck s had not yet paid for the sprinkling system. Stansworth agreed to accept a
three-month note for the full amount with interest at an annual rate of 14%.
Dec. 1 Chuck s Engineering paid the note in full.

EXERCISE 6-25 FACTORING RECEIVABLES AND BORROWING MONEY
Nixon Enterprises is experiencing a temporary shortage of cash. To cover the shortage, the fi-
nancial vice president of the company proposed that some of the company s accounts receiv-
able be sold (factored). A factoring company has offered to buy up to $2 million of the com-
pany s receivables on a without recourse basis at a fee of 16% of the amount factored.
As an alternative, another vice president of the company has proposed borrowing an
equivalent amount from South Willow Bank, pledging the outstanding receivables as collateral
for the loan. Under the terms of the borrowing agreement, Nixon Enterprises would receive
80% of the value of all receivables assigned to the bank and would be charged a 1% loan origi-
nation (service) fee based on the actual dollar amount of cash received and 12% annual interest
on the outstanding loan. The company estimates that the loan will be repaid in two months.
Evaluate the two alternatives. Which one is better from the company s perspective?

EXERCISE 6-26 ACCOUNTING FOR NOTES RECEIVABLE
Escondido Company frequently sells merchandise on promissory notes. The following transac-
tions relate to one such note:

Feb. 1 Sold merchandise for $9,000 to Marta Tabor; accepted a 6-month, 11% note.
Aug. 1 On this date (due date of the note), Marta Tabor did not make payment.
Oct. 1 Collected the maturity value (principal plus interest as of August 1) of the note from
Marta Tabor, together with 15% interest on the maturity value from August 1.
Prepare the journal entries to record the above transactions.

EXERCISE 6-27 FOREIGN CURRENCY TRANSACTION
Rabona Slice, a U.S. company, sold 100,000 cases of tropical fruit to Ben Thanh Market, a
Vietnamese firm, for 2.5 billion Vietnamese dong. The sale was made on November 17,
2003, when one U.S. dollar equaled 14,000 dong. Payment of 2.5 billion Vietnamese dong
was due to Rabona Slice on January 16, 2004. At December 31, 2003, one U.S. dollar
equaled 15,000 dong, and on January 16, 2004, one U.S. dollar equaled 15,600 dong.
1. What will be the value of the accounts receivable on December 31, 2003, in Vietnamese
dong?
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2. What will be the value of the accounts receivable on December 31, 2003, in U.S. dollars?
3. Will Rabona Slice recognize an exchange gain or loss at December 31, 2003? Explain.
4. Will Rabona Slice recognize an exchange gain or loss on January 16, 2004? Explain.
5. In connection with this sale, what amount will Rabona Slice report as Sales Revenue in
its income statement for 2003?
6. In connection with this sale, what amount will Rabona Slice report as Cash Collected
from Customers in its statement of cash flows for 2004?

EXERCISE 6-28 FOREIGN CURRENCY TRANSACTION
American, Inc., sells one widget to Japanese Company at an agreed-upon price of 1,000,000
yen. On the day of the sale, one yen is equal to $0.01. American, Inc., maintains its account-
ing records in U.S. dollars. Therefore, the amount in yen must be converted to U.S. dollars.
1. Provide the journal entry that would be made by American, Inc., on the day of the sale,
assuming Japanese Company pays for the widget on the day of the sale.
2. Most sales are on account, meaning that payment will not be received for 30 days or
even longer. What issues will arise for American, Inc., if the sale is made with payment
due in 30 days? (Hint: What might happen to the value of the yen in relation to the dol-
lar during the 30-day period?)
3. Suppose that 30 days from the date of the sale the value of one yen is equal to $0.008.
What journal entry would be made when the 1,000,000 yen are received by American, Inc.?




problems

PROBLEM 6-1 RECOGNIZING REVENUE
Brad Company sells ships. Each ship sells for over $25 million. Brad never starts building a ship
until it receives a specific order from a customer. Brad usually takes about four years to build a
ship. After construction is completed and during the first three years the customer uses the ship,
Brad agrees to repair anything on the ship free of charge. The customers pay for the ships over
a period of ten years after the date of delivery.
Brad Company is considering the following alternatives for recognizing revenue from its
sale of ships:
a. Recognize revenue when Brad receives the order to do the job.
b. Recognize revenue when Brad begins the work.
c. Recognize revenue proportionately during the four-year construction period.
d. Recognize revenue immediately after the customer takes possession of the ship.
e. Wait until the three-year guarantee period is over before recognizing any revenue.
f. Wait until the ten-year payment period is over before recognizing any revenue.
1. Which of the methods, (a) through (f), should Brad use to recognize revenue? Support
Required:
your answer.
2. Interpretive Question: A member of Congress has introduced a bill that would require
the SEC to crack down on lenient revenue recognition practices by shipbuilding compa-
nies. This bill would require Brad Company to use method (f) above. The logic behind
the congressperson s bill is that no revenue should ever be recognized until the complete
amount of cash is in hand. You have been hired as a lobbyist by Brad Company to speak
against this bill. What arguments would you use on Capitol Hill to sway representatives
to vote against this bill?

PROBLEM 6-2 RECOGNIZING REVENUE
The Ho Man Tin Tennis Club sells lifetime memberships for $20,000 each. A lifetime mem-
bership entitles a person to unlimited access to the club s tennis courts, weight room, exercise
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equipment, and swimming pool. Once a lifetime membership fee is paid, it is not refundable
for any reason.
Judy Chan and her partners are the owners of Ho Man Tin Tennis Club. In order to over-
come a cash shortage, they intend to seek investment funds from new partners. Judy and her
partners are meeting with their accountant to provide information for preparation of financial
statements. They are considering when they should recognize revenue from the sale of lifetime
memberships.

Required: Answer the following questions:
1. When should the lifetime membership fees be recognized as revenue? Remember, they
are nonrefundable.
2. Interpretive Question: What incentives would Judy and her partners have for recogniz-
ing the entire amount of the lifetime membership fee as revenue at the time it is col-
lected? Since the entire amount will ultimately be recognized anyway, what difference
does the timing make?


PROBLEM 6-3 SALES TRANSACTIONS
Company R and Company S entered into the following transactions:
a. Company R sold merchandise to Company S for $40,000, terms 2/10, n/30.
b. Prior to payment, Company S returned $3,000 of the merchandise for credit.
c. Company S paid Company R in full within the discount period.
d. Company S paid Company R in full after the discount period. [Assume that transaction
(c) did not occur.]

Prepare journal entries to record the transactions for Company R (the seller).
Required:


PROBLEM 6-4 CASH FRAUD
Mac Faber was the controller of the Lewiston National Bank. In his position of controller, he
was in charge of all accounting functions. He wrote cashier s checks for the bank and reconciled
the bank statement. He alone could approve exceptions to credit limits for bank customers, and
even the internal auditors reported to him. Unknown to the bank, Mac had recently divorced
and was supporting two households. In addition, many of his personal investments had soured,
including a major farm implement dealership that had lost $40,000 in the last year. Several
months after Mac had left the bank for another job, it was discovered that a vendor had paid
twice and that the second payment had been deposited in Mac s personal account. Because Mac
was not there to cover his tracks (as he had been on previous occasions), an investigation en-
sued. It was determined that Mac had used his position in the bank to steal $117,000 over a
period of two years. Mac was prosecuted and sentenced to 30 months in a federal penitentiary.
1. What internal control weaknesses allowed Mac to perpetrate the fraud?
Required:
2. What motivated Mac to perpetrate the fraud?


PROBLEM 6-5 ANALYSIS OF ALLOWANCE FOR BAD DEBTS
Boulder View Corporation accounts for uncollectible accounts receivable using the allowance
method.
As of December 31, 2002, the credit balance in Allowance for Bad Debts was $130,000.
During 2003, credit sales totaled $10,000,000, $90,000 of accounts receivable were written off
as uncollectible, and recoveries of accounts previously written off amounted to $15,000. An ag-
ing of accounts receivable at December 31, 2003, showed the following:
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Accounts Receivable Percentage
Balance as of Estimated
Classification of Receivable December 31, 2003 Uncollectible

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,140,000 2%
1 30 days past due . . . . . . . . . . . . . . . . . . . . . . . . 600,000 10
31 60 days past due . . . . . . . . . . . . . . . . . . . . . . . 400,000 23
Over 60 days past due . . . . . . . . . . . . . . . . . . . . . . 120,000 75
$2,260,000


1. Prepare the journal entry to record bad debt expense for 2003, assuming bad debts are
Required:
estimated using the aging of receivables method.
2. Record journal entries to account for the actual write-off of $90,000 uncollectible accounts
receivable and the collection of $15,000 in receivables that had previously been written off.


PROBLEM 6-6 ACCOUNTING FOR ACCOUNTS RECEIVABLE
Assume that Dome Company had the following balances in its receivable accounts on Decem-
ber 31, 2002:
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
Allowance for bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,200 (credit balance)

Transactions during 2003 were as follows:
Gross credit sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,600,000
Collections of accounts receivable ($1,560,000 less cash discounts
of $20,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,540,000
Sales returns and allowances (from credit sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Accounts receivable written off as uncollectible. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Balance in Allowance for Bad Debts on December 31, 2003
(based on percent of total accounts receivable) . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

1. Prepare entries for the 2003 transactions.
Required:
2. What amount will Dome Company report for:
a. Net sales in its 2003 income statement?
b. Total accounts receivable on its balance sheet of December 31, 2003?




PROBLEM 6-7 ANALYSIS OF RECEIVABLES
Juniper Company was formed in 1993. Sales have increased on the average of 5% per year during
its first ten years of existence, with total sales for 2002 amounting to $400,000. Since incorporation,
Juniper Company has used the allowance method to account for uncollectible accounts receivable.
On January 1, 2003, the company s Allowance for Bad Debts had a credit balance of $5,000.
During 2003, accounts totaling $3,500 were written off as uncollectible.
1. What does the January 1, 2003, credit balance of $5,000 in Allowance for Bad Debts
Required:
represent?
2. Since Juniper Company wrote off $3,500 in uncollectible accounts receivable during
2003, was the prior year s estimate of uncollectible accounts receivable overstated?
3. Prepare journal entries to record:
a. The $3,500 write-off of receivables during 2003.
b. Juniper Company s 2003 bad debt expense, assuming an aging of the December 31,
2003, accounts receivable indicates that potential uncollectible accounts at year-end
total $9,000.
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PROBLEM 6-8 COMPUTING AND RECORDING BAD DEBT EXPENSE
During 2003, Wishbone Corporation had a total of $5,000,000 in sales, of which 80% were
on credit. At year-end, the Accounts Receivable balance showed a total of $2,300,000, which
had been aged as follows:

Age Amount
Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,900,000
1 30 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
31 60 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
61 90 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Over 90 days past due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
$2,300,000


Prepare the journal entry required at year-end to record the bad debt expense under each of the
following independent conditions. Assume, where applicable, that Allowance for Bad Debts had
a credit balance of $5,500 immediately before these adjustments.
Required: 1. Use the direct write-off method. (Assume that $60,000 of accounts are determined to be
uncollectible and are written off in a single year-end entry.)
2. Based on experience, uncollectible accounts existing at year-end are estimated to be 3%
of total accounts receivable.
3. Based on experience, uncollectible accounts are estimated to be the sum of:

1% of current accounts receivable
6% of accounts 1 30 days past due
10% of accounts 31 60 days past due
20% of accounts 61 90 days past due
30% of accounts over 90 days past due


PROBLEM 6-9 UNIFYING CONCEPTS: AGING OF ACCOUNTS RECEIVABLE
AND UNCOLLECTIBLE ACCOUNTS
Delta Company has found that, historically, 0.5% of its current accounts receivable, 1% of ac-
counts 1 to 30 days past due, 1.5% of accounts 31 to 60 days past due, 3% of accounts 61 to
90 days past due, and 10% of accounts over 90 days past due are uncollectible. The following
schedule shows an aging of the accounts receivable as of December 31, 2003:

Days Past Due
Current 1 30 31 60 61 90 Over 90

Balance . . . . . . . . . . . . $45,600 $9,850 $4,100 $850 $195


The balances at December 31, 2003, in selected accounts are as follows. (Assume that the
allowance method is used.)
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,096
Sales returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,209
Allowance for bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 (credit balance)

Required: 1. Given these data, make the necessary adjusting entry (or entries) for uncollectible ac-
counts receivable on December 31, 2003.
2. On February 14, 2004, Lori Jacobs, a customer, informed Delta Company that she was
going bankrupt and would not be able to pay her account of $46. Make the appropriate
entry (or entries).
3. On June 29, 2004, Lori Jacobs was able to pay the amount she owed in full. Make the
appropriate entry (or entries).
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4. Assume that Allowance for Bad Debts at December 31, 2003, had a debit balance of
$113 instead of a credit balance of $113. Make the necessary adjusting journal entry that
would be needed on December 31, 2003.

PROBLEM 6-10 ESTIMATING UNCOLLECTIBLE ACCOUNTS
Ulysis Corporation makes and sells clothing to fashion stores throughout the country. On De-
cember 31, 2003, before adjusting entries were made, it had the following account balances on
its books:
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,320,000
Sales revenue, 2003 (60% were credit sales) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000,000
Allowance for bad debts (credit balance) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000

Required: 1. Make the appropriate adjusting entry on December 31, 2003, to record the allowance for
bad debts if uncollectible accounts receivable are estimated to be 3% of accounts receiv-
able.
2. Make the appropriate adjusting entry on December 31, 2003, to record the allowance for
bad debts if uncollectible accounts receivable are estimated on the basis of an aging of ac-
counts receivable; the aging schedule reveals the following:

Balance of Accounts Percent Estimated to
Receivable Become Uncollectible

Current . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000 0.5%
1 30 days past due . . . . . . . . . . . . . . . . . . 800,000 1
31 60 days past due . . . . . . . . . . . . . . . . . 200,000 4
61 90 days past due . . . . . . . . . . . . . . . . . 80,000 20
Over 90 days past due. . . . . . . . . . . . . . . . 40,000 30


3. Now assume that on March 3, 2004, it was determined that a $64,000 account receiv-
able from Petite Corners is uncollectible. Record the bad debt, assuming:
a. The direct write-off method is used.
b. The allowance method is used.
4. Further assume that on June 4, 2004, Petite Corners paid this previously written-off debt
of $64,000. Record the payment, assuming:
a. The direct write-off method had been used on March 3 to record the bad debt.
b. The allowance method had been used on March 3 to record the bad debt.
5. Interpretive Question: Which method of accounting for bad debts, direct write-off or
allowance, is generally used? Why?

PROBLEM 6-11 THE AGING METHOD
The following aging of accounts receivable is for Coby Company at the end of 2003:

Aging of Accounts Receivable
December 31, 2003
Less Than 30 31 to 60 61 to 90 Over 90
Overall Days Days Days Days

Travis Campbell $ 50,000 $ 40,000 $ 5,000 $ 2,000 $ 3,000
Linda Reed 35,000 31,000 4,000
Jack Riding 110,000 100,000 10,000
Joy Riddle 20,000 3,000 10,000 4,000 3,000
Afzal Shah 90,000 60,000 21,000 4,000 5,000
Edna Ramos 80,000 60,000 16,000 4,000
Totals $385,000 $294,000 $66,000 $10,000 $15,000
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Coby Company had a credit balance of $20,000 in its allowance for bad debts account at
the beginning of 2003. Write-offs for the year totaled $16,500. Coby Company makes only
one adjusting entry to record bad debt expense at the end of the year. Historically, Coby
Company has experienced the following with respect to the collection of its accounts re-
ceivable:


Percentage
Ultimately
Age of Account Uncollectible

Less than 30 days 1%
31 60 days 5
61 90 days 30
Over 90 days 90



Required: 1. Compute the appropriate balance of allowance for bad debts as of December 31, 2003.
2. Make the journal entry required to record this allowance for bad debts balance. Remem-
ber that the allowance account already has an existing balance.
3. What is Coby s net accounts receivable balance as of December 31, 2003?


ANALYSIS OF ACCOUNTS RECEIVABLE QUANTITY AND
PROBLEM 6-12
QUALITY
The following accounts receivable information is for MaScare Company:


2003 2002 2001
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . $100,000 $ 30,000 $ 50,000
Allowance for bad debts . . . . . . . . . . . . . . . . . . . . 4,000 2,000 3,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000 180,000 170,000



1. With the big increase in the Allowance for Bad Debts in 2003, MaScare Company is
Required:
concerned that the creditworthiness of its customers declined from 2002 to 2003. Is
there any support for this view in the accounts receivable data? Explain.
2. Interpretive Question: Is there any cause for alarm in the accounts receivable data for
2003? Explain.




PROBLEM 6-13 PREPARING A BANK RECONCILIATION
Milton Company has just received the following monthly bank statement for June 2003.

Date Checks Deposits Balance
June 01 $25,000
June 02 $ 150 24,850
June 03 $ 6,000 30,850
June 04 750 30,100
June 05 1,500 28,600
June 07 8,050 20,550
(continued)
284 f285
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Date Checks Deposits Balance
June 09 $ 8,000 $28,550
June 10 $ 3,660 24,890
June 11 2,690 22,200
June 12 9,000 31,200
June 13 550 30,650
June 17 7,500 23,150
June 20 5,500 28,650
June 21 650 28,000
June 22 700 27,300
June 23 4,140 31,440
June 25 1,000 30,440
June 30 50* 30,390
Totals $27,250 $32,640


*Bank service charge.
Note collected, including $140 interest.



Data from the cash account of Milton Company for June are as follows:

June 1 balance . . . . . . . . . . . . . . . . . $20,440

Checks written: Deposits:
June 1 . . . . . . . . . . . . . . . . . . . . . . . $ 1,500 June 2 . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
4....................... 8,500 5. . . . . . . . . . . . . . . . . . . . . . . 8,000
6....................... 2,690 10 . . . . . . . . . . . . . . . . . . . . . . . 9,000
8....................... 550 18 . . . . . . . . . . . . . . . . . . . . . . . 5,500
9....................... 7,500 30 . . . . . . . . . . . . . . . . . . . . . . . 6,000
12 . . . . . . . . . . . . . . . . . . . . . . . 650 $34,500
19 . . . . . . . . . . . . . . . . . . . . . . . 700
22 . . . . . . . . . . . . . . . . . . . . . . . 1,000
26 . . . . . . . . . . . . . . . . . . . . . . . 1,300
27 . . . . . . . . . . . . . . . . . . . . . . . 1,360
$25,750

At the end of May, Milton had three checks outstanding for a total of $4,560. All three checks
were processed by the bank during June. There were no deposits outstanding at the end of May.
It was discovered during the reconciliation process that a check for $8,050, written on June 4
for supplies, was improperly recorded on the books as $8,500.

1. Determine the amount of deposits in transit at the end of June.
Required:
2. Determine the amount of outstanding checks at the end of June.
3. Prepare a June bank reconciliation.
4. Prepare the journal entries to correct the cash account.
5. Interpretive Question: Why is it important that the cash account be reconciled on a
timely basis?



PROBLEM 6-14 DETERMINING WHERE THE CASH WENT
Kim Lee, the bookkeeper for Briton Company, had never missed a day s work for the past ten
years until last week. Since that time, he has not been located. You now suspect that Kim may
have embezzled money from the company. The following bank reconciliation, prepared by Kim
last month, is available to help you determine if a theft occurred:
285
f286 Selling A Product Or A Service
Part 2 EOC Operating Activities



Briton Company
Bank Reconciliation for August 2003
Prepared by Kim Lee

Balance per bank statement . . . . . $192,056 Balance per books . . . . . . . . . . . . . $169,598
Additions to bank balance: Additions to book balance:
Deposits in transit. . . . . . . . . . . . . 8,000 Note collected by bank . . . . . . . .. 250
Interest earned . . . . . . . . . . . . . .. 600
Deductions from bank balance: Deductions from book balance:
Outstanding checks: NSF check . . . . . . . . . . . . . . . . . .. (1,800)
#201 . . . . . . . . . . . . . . .. (19,200) Bank service charges. . . . . . . . . .. (48)
#204 . . . . . . . . . . . . . . .. (5,000)
#205 . . . . . . . . . . . . . . .. (4,058)
#295 . . . . . . . . . . . . . . .. (195)
#565 . . . . . . . . . . . . . . .. (1,920)
#567 . . . . . . . . . . . . . . .. (615)
#568 . . . . . . . . . . . . . . .. (468)
Adjusted bank balance . . . . . . . .. $168,600 Adjusted book balance . . . . . . . . . $168,600


In examining the bank reconciliation, you decide to review canceled checks returned by the bank.
You find that check stubs for check nos. 201, 204, 205, and 295 indicate that these checks were
supposedly voided when written. All other bank reconciliation data have been verified as correct.
1. Compute the amount suspected stolen by Kim.
Required:
2. Interpretive Question: Describe how Kim accounted for the stolen money. What would
have prevented the theft?

PROBLEM 6-15 ACCOUNTING FOR A NOTE RECEIVABLE
The following information is for Lyman Irrigation Company:
Mar. 1 Sold sprinkling pipe to Federated Farms for $16,000, terms 2/10, n/30 (omit entries
for cost of goods sold or inventory).
Mar. 12 Accepted a $16,000, three-month, 10% note from Federated Farms in payment of
its account.
June 12 Collected the note plus interest.
Required: 1. Prepare journal entries for the transactions.
2. Interpretive Question: What would be the purpose of Lyman discounting the note at
a bank on April 30?

PROBLEM 6-16 ACCOUNTING FOR A NOTE RECEIVABLE
On May 1, your company accepted a $24,000, three-month, 12% note from a customer in ex-
change for services rendered.
Required: 1. As the accountant for the company, prepare an appropriate journal entry to record the
acceptance of the note.
2. On August 1, the customer notified you that the note amount could not be repaid until
October 1. You agreed on a new, two-month note with an interest rate of 18%. The face
amount of this note includes the principal and accrued interest on the original note. Pre-
pare the appropriate journal entry on August 1.
3. Prepare the appropriate entry to record the collection in full of the note plus interest on
October 1.

PROBLEM 6-17 ACCOUNTING FOR A FOREIGN CURRENCY TRANSACTION
On December 19, 2003, Mr. Kitty Company performed services for Cartour Company. The
contracted price for the services was 20,000 euros, to be paid on March 23, 2004. On Decem-
286 f287
Selling A Product Or A Service CEO Chapter 6
Selling a Product or a Service



ber 19, 2003, one euro equaled $0.94. On December 31, 2003, one euro equaled $0.98, and
on March 23, 2004, one euro equaled $0.91. Mr. Kitty is a U.S. company.
Required: 1. Make the journal entry on Mr. Kitty s books to record the provision of services on De-
cember 19, 2003.
2. Make the necessary adjusting entry on Mr. Kitty s books on December 31 to adjust the
account receivable to its appropriate U.S. dollar value.
3. Make the journal entry on Mr. Kitty s books to record the collection of the 20,000 euros
on March 23.
4. Interpretive Question: Why would Mr. Kitty, a U.S. company, agree to denominate the
contract in euros instead of in U.S. dollars?




competency enhancement opportunities


LLL
LLLL




Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
L




ANALYZING REAL COMPANY INFORMATION
Analyzing 6-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Locate that
annual report and consider the following questions:
1. Provide the summary journal entry that Microsoft would have made to
record its revenue for the fiscal year ended June 30, 1999 (assume all sales
were on account).
2. Given Microsoft s beginning and ending balances in accounts receivable,
along with your journal entry from Part 1, estimate the amount of cash col-
lected from customers during the year.
3. Notice that Microsoft has an unearned revenue account. The balance in that
account increased from 1998 to 1999. Provide the summary journal entry
that was made to record that increase.
4. Locate Microsoft s note on revenue recognition. What is Microsoft s rev-
enue recognition policy?
Analyzing 6-2 (Bank of America)
BANK OF AMERICA is one of the oldest banks in America, as well as one of
the largest. Founded in the late 1800s, Bank of America has grown from a
strictly California-based bank to one with operations in over 20 states. Infor-
mation from Bank of America s annual report follows. (Amounts are in mil-
lions.)
287
f288 Selling A Product Or A Service
Part 2 CEO Operating Activities




1999 1998

Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,820 $2,920
Write-off of uncollectible accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,582 3,050
Allowance for bad debts (year-end) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,828 7,122


Using this information, answer the following questions:
1. Provide the journal entry made by Bank of America to record bad debt ex-
pense for 1999.
2. Provide the journal entry made by Bank of America to record the write-off
of actual bad debts during 1999.
3. Estimate the amount of bad debts previously written off that Bank of Amer-
ica recovered in 1999.
Analyzing 6-3 (Microsoft and IBM)
Information from comparative income statements and balance sheets for MI-
CROSOFT and IBM is given below. (Amounts are in millions.)

Microsoft IBM
1999 1998 1999 1998

Sales $19,747 $15,262 $87,548 $81,667
Accounts receivable 2,245 1,460 20,039 18,958


Use this information to answer the following questions:
1. Compute Microsoft s average collection period for 1999.
2. Compute IBM s average collection period for 1999.
3. Why do you think these two very profitable companies can have such large
differences in their average collection period?
L




INTERNATIONAL CASE
Samsung
The economic downturn in South Korea in late 1997 focused world attention
on what had heretofore been viewed as one of the world s economic power-
houses. Symptomatic of the economic collapse was the freefall in Korea s cur-
rency, the won, which declined in value from 845 won per U.S. dollar on De-
cember 31, 1996, to 1,695 won per dollar on December 31, 1997.
When Korea s economy soured, many sought to blame the economy s un-
usual structure, which concentrates a large fraction of the economic activity in
the hands of just a few companies, called chaebol. Chaebol are large Korean
conglomerates (groups of loosely connected firms with central ownership) that
are usually centered around a family-owned parent company. The growth of
the chaebol in the years since the Korean War has been aided by government
nurturing it is said that the chaebol have received government assistance in
getting loans and obtaining trading licenses, for example.
In Korea there are now four super-chaebol HYUNDAI, SAMSUNG, DAE-
WOO, and LUCKY GOLDSTAR. Collectively, these four conglomerates account
for between 40 and 45% of South Korea s gross national product.
Samsung, one of the four super-chaebol, was founded in 1938 in Taegu,
Korea. The company had humble beginnings; its original products included
288 f289
Selling A Product Or A Service CEO Chapter 6
Selling a Product or a Service




fruit, dried seafood, flour, and noodles, and its original exports were squid and
apples. Now, Samsung has a worldwide presence in electronics, machinery,
automobiles, chemicals, and financial services. To illustrate the size of Sam-
sung s operations, it is estimated that one out of every five televisions or mon-
itors in the world was made by Samsung.
The following information is from Samsung s 1997 annual report. All num-
bers are in trillions of Korean won.


1997 1996

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91.519 74.641
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.064 6.233


1. Did Samsung s sales increase in 1997, relative to 1996, in terms of U.S. dol-
lars? Explain. What exchange rate information would allow you to make a
more accurate calculation?
2. Compute Samsung s average collection period for both 1996 and 1997. In-
stead of using the average accounts receivable balance, use the end-of-
year balance.
3. Comment on the change in the average collection period from 1996 to 1997,
especially in light of the economic conditions in Korea in 1997.
4. What do you think happened to Samsung s accounts payable balance in
1997, relative to 1996? Explain.
L




ETHICS CASE
Changing Our Estimates in Order to Meet Analysts Expectations
John Verner is the controller for BioMedic, Inc., a biotechnology company. John
is finishing his preparation of the preliminary financial statements for a meet-
ing of the board of directors scheduled for later in the day. At the board s prior
meeting, members discussed the need to report earnings of at least $1.32 per
share. It was not mentioned specifically at the meeting, but everyone on the
board knows that financial analysts have forecast that BioMedic will report
earnings per share (EPS) of $1.32; failure to meet analysts expectations could
hurt BioMedic s chances of going forward with its planned initial public offer-
ing (IPO) later this year.
Unfortunately for John and the company, the preliminary EPS figure is com-
ing up short. John knows that the board will take a serious look at the esti-
mates and assumptions made in preparing the income statement. In anticipa-
tion of the board s review, John has identified the following two issues:
1. In the past, bad debt expense has been computed using the percentage of
sales method. The percentage used has varied between 3 and 3.5%. This
year, John assumed a rate of 3%. If he were to modify his estimate of bad
debt expense to 2.5% of sales, income would increase by $700,000.
2. BioMedic, Inc., offers a warranty on many of the products it sells. Like bad
debt expense, warranty expense is computed as a percentage of sales. John
is considering modifying his estimate of warranty expense from 1.4% of
sales down to 1.1%. This modification would result in a $420,000 increase
in net income.
These two changes, considered together, would result in BioMedic being able
to report EPS of $1.33 per share, thereby allowing the company to publicly an-
289
f290 Selling A Product Or A Service
Part 2 CEO Operating Activities




nounce that it had exceeded analysts expectations. Without these changes,
BioMedic will report EPS of $1.21 per share.
What issues should John consider before he makes the changes to the in-
come statement? Would John be doing something wrong by making these
changes? Would John be breaking the law?
L
WRITING ASSIGNMENT
Revenue Recognition for Health Clubs
The health fitness business has become increasingly popular as the sedentary
lifestyle of most Americans has caused a large percentage of the population
to feel, and be, out of shape. Health clubs have popped up all over, and with
these clubs come some interesting accounting issues. Members typically sign
up for one year and pay an up-front fee, followed by a monthly payment. The
up-front fee covers, among other things, a health assessment by a club expert
as well as a customized training program. For the monthly fee, members get
the use of the facilities. The big accounting question is: How should the up-
front fee be accounted for? Can the entire amount of the up-front fee be rec-
ognized at the beginning of the contract, or should it be recognized over the
course of the year? Prepare a one-page paper explaining your point of view.
L




THE DEBATE
Bad Debt Expense: Relevance Versus Reliability
When it comes to recognizing bad debt expense, the allowance method is used
because it complies with the matching principle (e.g., expenses are matched
with revenues in the period in which those revenues are earned). However, the
allowance method requires estimation, and the estimates may not be reliable.
An alternative is to use the direct write-off method. Under the direct write-off
method, when a receivable is deemed worthless it is written off, and the bad
debt expense is recognized at that time. This method requires no estimates
and is thus more reliable.
Divide your group into two teams.
One team represents The Direct Write-Off Method. Prepare a two-minute
oral argument supporting the use of this method.
The other team represents The Allowance Method. Prepare a two-minute
presentation supporting your position.
L




CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one. If needed, review the spreadsheet assignment for Chapter 4
to refresh your memory on how to construct forecasted financial statements.
1. Handyman wishes to prepare a forecasted balance sheet and income state-
ment for 2004. Use the original financial statement numbers for 2003 [given
in part (1) of the Cumulative Spreadsheet Project assignment in Chapter 2]
as the basis for the forecast, along with the following additional informa-
tion:
a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.
b. In 2004, Handyman expects to acquire new property, plant, and equip-
ment costing $80.
290 f291
Selling A Product Or A Service CEO Chapter 6
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c. The $160 in other operating expenses reported in 2003 includes $5 of
depreciation expense.
d. No new long-term debt will be acquired in 2004.
e. No cash dividends will be paid in 2004.
f. New short-term loans payable will be acquired in an amount sufficient
to make Handyman s current ratio in 2004 exactly equal to 2.0.
Note: These statements were constructed as part of the spreadsheet assign-
ment in Chapter 4; you can use that spreadsheet as a starting point if you have
completed that assignment.
For this exercise, the current assets are expected to behave as follows:
i. Cash and inventory will increase at the same rate as sales.
ii. The forecasted amount of accounts receivable in 2004 is determined
using the forecasted value for the average collection period. For sim-
plicity, do the computations using the end-of-period accounts receiv-
able balance instead of the average balance. The average collection pe-
riod for 2004 is expected to be 14.08 days.
Clearly state any additional assumptions that you make.
2. Repeat (1), with the following change in assumptions:
a. Average collection period is expected to be 9.06 days.
b. Average collection period is expected to be 20.00 days.
3. Comment on the differences in the forecasted values of accounts receiv-
able in 2004 under each of the following assumptions about the average
collection period: 14.08 days, 9.06 days, and 20.00 days. Under which as-
sumption will Handyman s forecasted cash flow from operating activities
be higher? Explain.
L




INTERNET SEARCH
Yahoo!
YAHOO! is one of the best-known Internet brand names in the world. Access
Yahoo! s Web site at http://www.yahoo.com and answer the following ques-
tions. Sometimes Web addresses change, so if this address doesn t work, ac-
cess the Web site for this textbook (http://albrecht.swcollege.com) for an up-
dated link.
1. On its home page, Yahoo! has a link to information about job openings at
the company. Use that link to find out what kind of benefits Yahoo! offers
its employees.
2. Look at the current job openings at Yahoo! and identify one opening in the
general field of finance.
3. Yahoo! is proud of the proliferation of local Yahoos! based in foreign
countries. List the Asian countries in which a local Yahoo! is currently in
operation.
4. Search the Yahoo! press release archive to find the most recent an-
nouncement about quarterly financial results. What was Yahoo! s reported
total revenue in the most recent quarter?
Inventory

chapter



7
f7
learning objectives After studying this chapter, you should be able to:

understand the impact of
1 Identify what items and 8 Apply the lower-of-cost-or-
errors in ending inventory
costs should be included in market method of
on reported cost of goods
inventory and cost of goods accounting for inventory.
sold.
sold.
6 Analyze the impact of
9 Explain the gross margin
4 inventory errors on reported
Apply the four inventory
2 Account for inventory method of estimating
cost of goods sold.
cost flow alternatives:
purchases and sales using inventories.
specific identification, FIFO,
both a perpetual and a
7 Describe the complications
LIFO, and average cost.
periodic inventory system. that arise when LIFO or
5 Use financial ratios to average cost is used with a
3 Calculate cost of goods sold perpetual inventory system.
evaluate a company s
using the results of an
inventory level.
inventory count and
292 chapter f7
Inventory


The 1980s was a decade of diversifi-
SEARS, ROEBUCK & COMPANY began as
cation at Sears. Actually, the diversifica-
the result of an inventory mistake. In 1886,
tion had begun in 1931 when Sears started
a shipment of gold watches was mistak-
selling ALLSTATE auto insurance, first by
enly sent to a jeweler in Redwood Falls,
mail and then from its retail locations. In
Minnesota. When the jeweler refused to
the 1980s, Sears acquired DEAN WITTER,
accept delivery of the unwanted watches,
a financial services firm, and COLDWELL
they were purchased by an enterprising
BANKER, a real estate firm. In addition,
railroad agent who saw an opportunity to
Sears launched the Discover¬ credit card
make some money. Richard Sears sold all
and backed Prodigy¬ , the first widespread
of those watches, ordered more, and
started the R. W. SEARS WATCH COM- online service (a joint project with IBM and
PANY. The next year, Sears moved his op- CBS).
eration to Chicago, where he found a part- In the early 1990s, the diversified Sears
ner in watchmaker Alvah Roebuck, and in empire began to show increasing weak-
1893 they incorporated under the name ness, culminating in a reported loss of al-
Sears, Roebuck & Co. most $2.3 billion in 1992. The company s
The company s initial growth was fu- management responded by going back to
eled by mail-order sales to farmers. Sears the basics of retail marketing. The financial
bought goods in volume from manufac- services operations (including the Discover
turers. Then, taking advantage of cheap card) and the real estate operations (along
parcel post and rural free delivery (RFD) with the famous Sears Tower in Chicago)
rates, Sears shipped the goods directly to were sold. Sears focused on clothing sales
the customers, thereby bypassing the in its mall-based stores and appliance and
profit markups of the chain of middlemen automotive product sales in its off-the-mall
usually standing between manufacturers stores. In addition, Sears returned to em-
and farmers. Sales growth was partially phasizing its in-house Sears credit card. In
driven by the persuasive advertising copy 1999, almost half of all Sears sales were
written by Richard Sears for the famous financed with the Sears credit card. During
Sears catalog. In fact, his product descrip- 1999, over 39 million people used the Sears
tions have been politely called fanciful. card, and over 21 million owed Sears
setting the stage
But the company compensated by backing money as of the end of the year.
its products with an unconditional money- Sears is continuing to leverage one of
back guarantee for dissatisfied customers. its biggest assets its in-house brand
The next wave of growth at Sears be- names such as Kenmore and Craftsman.
gan in 1925 when the first Sears retail store In fact, sales of Sears appliances and tools
was opened in Chicago. The shift from make up two-thirds of the company s an-
mail-order catalog sales to retail outlet nual revenue. Currently, Sears is the leader
sales paralleled the rise in popularity of the in appliance sales and outsells the next 12
automobile in the United States. The au- competitors combined. Sears has also
tomobile made it practical for rural cus- streamlined its purchasing, cut 30% of its
tomers to shop in the city. Reflecting the dealer network, and is keeping more pop-
importance of the automobile, Sears pio- ular fashions in stock in its clothing de-
neered the provision of free parking lots partment. This streamlining has resulted in
next to its stores. In the post World War II higher inventory turnover. As a result of
boom, Sears sales skyrocketed, leaving these changes and others, Sears stock
chief rival MONTGOMERY WARD far be- price has risen from $15 per share in 1992
to as high as $50 per share in 1999.1
hind.




Like Sears, every business has products or services that it sells. Some companies, usually referred to
as diversified companies or conglomerates, sell many unrelated products and services, just as Sears
did in the 1980s. Other companies focus on a core set of products or services, as Sears did in the
1990s.
In Chapter 6, the focus was on revenues and receivables arising from the sale of products and
services. In this chapter, the focus is on accounting for the products and services that are sold.


1 This description is based on the Sears Company History at http://www.sears.com; Sears, Roebuck and Co.,
International Directory of Company Histories, Vol. 18 (Detroit: St. James Press, 1997), pp. 475 479.
293
f294 Part 2 Inventory
Operating Activities


Exhibit 7-1 shows how the financial statements are affected by the material covered in this chap-
ter. The inventory and accounts payable accounts on the balance sheet, cost of goods sold on the
income statement, and payments for inventory on the statement of cash flows are discussed in this
chapter.
Traditionally, companies have been divided into two groups: service companies and product
companies. Companies such as hotels, cable TV networks, banks, carpet cleaners, and firms of lawyers,
accountants, or engineers sell services. In contrast, supermarkets, steel mills, and
The clear separation be- book stores sell products. Because the practice of accounting evolved in a business
tween product and service companies is environment dominated by manufacturing and merchandising firms, the account-
ing for service companies is significantly less developed than the accounting for com-
disappearing. For example, does MI-
CROSOFT sell a product or a service? What panies that sell products. In this chapter we discuss traditional accounting for prod-
uct companies, emphasizing cost of goods sold and inventory. In Chapter 8 we will
about MCDONALD S product or service?
discuss operating expenses that are common to both service and product firms. Fur-
ther discussion of the developing area of accounting for service companies is included in Chapter 3
in the management accounting part of this text.
Inventory accounting is considerably more complex for manufacturing firms than for merchan-
dising firms. In a retail or wholesale business, the cost of goods sold is simply the costs incurred in
purchasing the merchandise sold during the period; inventory is simply the cost of products purchased
and not yet sold. Manufacturing firms, however, produce the goods they sell, so inventory and cost
of goods sold must include all manufacturing costs of the products produced and sold. Because it is
much easier to understand the concept of inventory and cost of goods sold in the context of retail and
wholesale firms, manufacturing firms will not be considered in detail in this chapter. The details of
inventory accounting for manufacturing firms will be covered in Chapter 2 in the management ac-
counting part of this text.
Fifty years ago, inventory was arguably the most important asset on the balance sheet. How-
ever, changes in the economy have led to a decrease in the relative importance of inventory. For ex-
ample, as illustrated in Exhibit 7-2, inventory for the 50 largest companies in the United States de-
clined steadily from 15.4% of total assets in 1987 to 7.4% of total assets in 1998. This trend is a




Financial Statement Items Covered in This Chapter
exhibit 7-1


Statement of
Balance Sheet Cash Flows
Operating activities
Current assets
Payments for
Inventory
inventory
Current liabilities
Accounts payable




Income
Statement
Cost of goods sold
294 f295
Inventory Chapter 7
Inventory



How Much Inventory Do Companies Have?
exhibit 7-2
Inventory as a Percentage of Total Assets




16%

15%

14% Inventory Levels for the
50 Largest Companies, 1979“1998
13%

12%

11%

10%

9%

8%

7%
85
81

82

83




88
79




84




86

87




89




93
80




90

91

92




95

96
94




97

98
19
19

19

19




19
19




19




19

19




19




19
19




19

19

19




19

19
19




19

19
Source: Standard and Poor™s COMPUSTAT.



result of two factors: more efficient management of inventory because of improved information tech-
nology and a decrease in the prominence of old-style, smokestack industries that carried large in-
ventories. Companies in the growth industries of services, technology, and information often have
little or no inventory.


1 INVENTORY AND COST OF GOODS SOLD
Identify what items and
Inventory is the name given to goods that are either manufactured or purchased for resale in
costs should be included in
inventory and cost of goods the normal course of business. A car dealer s inventory is comprised of automobiles; a grocery
sold.
store s inventory consists of vegetables, meats, dairy products, canned goods, and bakery items;
SEARS inventory is composed of shirts, appliances, DieHard¬ batteries, and more. Like other
inventory Goods held for
resale. items of value, such as cash or equipment, inventory is classified as an asset and reported on the
balance sheet. When products are sold, they are no longer assets. The costs to purchase or man-
cost of goods sold The
ufacture the products must be removed from the asset classification (inventory) on the balance
expenses incurred to pur-
sheet and reported on the income statement as an expense cost of goods sold.
chase or manufacture the
merchandise sold during The time line in Exhibit 7-3 illustrates the business issues involved with inventory.
a period.


Time Line of Business Issues Involved with Inventory
exhibit 7-3

COMPUTE
BUY ADD SELL




cost of
raw materials or ending
value finished
goods sold
goods for resale inventory
inventory
295
f296 Part 2 Inventory
Operating Activities


The accounting questions associated with the items in the time line are as follows:
When is inventory considered to have been purchased when it is ordered, shipped, re-
ceived, or paid for?
Similarly, when is the inventory considered to have been sold?
Which of the costs associated with the value added process are considered to be part of
the cost of inventory, and which are simply business expenses for that period?
How should total inventory cost be divided between the inventory that was sold (cost of
goods sold) and the inventory that remains (ending inventory)?
These questions are addressed in the following sections of the chapter.

What Is Inventory?
In a merchandising firm, either wholesale or retail, inventory is composed of the items that have
been purchased in order to be resold. In a supermarket, milk is inventory, a shopping cart is
not. In a manufacturing company, there are three different types of inventory: raw materials,
work in process, and finished goods.

Raw materials are goods acquired in a relatively undeveloped state that
RAW MATERIALS
raw materials Materials
purchased for use in manu- will eventually compose a major part of the finished product. If you are making bicycles, one
facturing products. of the raw materials is tubular steel. For a computer assembler, raw materials inventory is com-
posed of plastic, wires, and INTEL Pentium¬ chips.

Work in process consists of partially finished products. When you
WORK IN PROCESS
work in process Partially
completed units in produc- take a tour of a manufacturing plant, you are seeing work-in-process inventory.
tion.
Finished goods are the completed products waiting for sale. A com-
FINISHED GOODS
finished goods Manufac-
tured products ready for pleted car rolling off the automobile assembly line is part of finished goods inventory.
sale.

What Costs Are Included in Inventory Cost?
Inventory cost consists of all costs involved in buying the inventory and preparing it for sale. In
the case of raw materials or goods acquired for resale by a merchandising firm, cost includes the
purchase price, freight, and receiving and storage costs.
The cost of work-in-process inventory is the sum of the costs of the raw materials, the pro-
duction labor, and some share of the manufacturing overhead required to keep the factory run-
ning. The cost of an item in finished goods inventory is the total of the materials, labor, and
overhead costs used in the production process for that item. As you can imagine, accumulating
these costs and calculating a cost per unit is quite a demanding task. The cost of a finished au-
tomobile includes the cost of the steel and rubber; the salaries and wages of assembly workers,
inspectors, and testers; the factory insurance; the workers pension benefits; and much more.
This costing process is a key part of management accounting and is covered in Chapter 2 in the
management accounting part of the text.
The costs just described are all costs expended in order to get inventory produced and ready
to sell. These costs are appropriately included in inventory costs. Those costs incurred in the
sales effort itself are not inventory costs, but instead should be reported as operating expenses in
the period in which they are incurred. For example, the costs of maintaining the finished goods
warehouse or the retail showroom are period expenses. Salespersons salaries are period expenses,
as is the cost of advertising (a more detailed discussion of advertising is included in Chapter 8).
In addition, general nonfactory administrative costs are also period expenses. Examples are the
costs of the corporate headquarters and the company president s salary.

Who Owns the Inventory?
As a general rule, goods should be included in the inventory of the business holding legal title.
So, a merchandising firm is considered to have purchased inventory once it has legal title to the
inventory. Similarly, the inventory is considered to be sold when legal title passes to the cus-
296 f297
Inventory Chapter 7
Inventory


tomer. In most cases, this legal title rule is easy to apply if you go into a business and look
around, it is probably safe to assume that the inventory you see belongs to that business. In the
case of goods in transit and goods on consignment, however, this legal title rule can be rather
difficult to apply.

When goods are being shipped from the seller to the buyer, who owns
GOODS IN TRANSIT
the inventory that is on a truck or railroad car the seller or the buyer? If the seller pays for the
shipping costs, the arrangement is known as FOB (free-on-board) destination, and the seller
FOB (free-on-board) desti-
nation A business term owns the merchandise from the time it is shipped until it is delivered to the buyer. If the buyer
meaning that the seller of pays the shipping costs, the arrangement is known as FOB (free-on-board) shipping point,
merchandise bears the
and the buyer owns the merchandise during transit. Thus, in determining which items should
shipping costs and main-
be counted and included in the inventory balance for a period, a company must note the amount
tains ownership until the
of merchandise in transit and the terms under which it is being shipped. In all cases, merchan-
merchandise is delivered to
the buyer. dise should be included in the inventory of the party who owns it; for goods in transit, this is
generally the party who is paying the shipping costs. The impact of shipping terms on the own-
FOB (free-on-board) ship-
ership of goods in transit is summarized in Exhibit 7-4.
ping point A business term
meaning that the buyer of
merchandise bears the Sometimes the inventory a firm stocks in its warehouse has
GOODS ON CONSIGNMENT
shipping costs and acquires not actually been purchased from suppliers. With a consignment arrangement, suppliers (the
ownership at the point of
consignors) provide inventory for resale while retaining ownership of the inventory until it is
shipment.
sold. The firm selling the merchandise (the consignee) merely stocks and sells the merchandise
consignment An arrange- for the supplier/owner and receives a commission on any sales as payment for services rendered.
ment whereby merchandise Through a consignment arrangement, the manufacturer enables dealers to acquire a broad sam-
owned by one party, the
ple of inventory without incurring the purchase and finance charges required to actually buy the
consignor, is sold by an-
inventory. It is extremely important that goods being held on consignment not be included in
other party, the consignee,
the inventory of the firm holding the goods for sale even though they are physically on that
usually on a commission
basis. firm s premises. It is equally important that the supplier/owner properly include all such goods
in its records even though the inventory is not on its premises.
Auditing goods in transit and consigned inventory presents the auditor with a special set of
problems. Inventory that is on the premises may not belong to the company because the goods
are held on consignment. On the other hand, goods that are in transit in trucks and boats scat-
tered around the world may belong to the company and should be included in the inventory
count.
An example of a company that successfully uses consignment sales as part of its business
strategy is INTERNATIONAL AIRLINE SUPPORT GROUP, INC. This company is a lead-
ing distributor of aircraft spare parts for large jet airplanes. The company uses consignments be-
cause, as stated in its annual report, this arrangement allows it to obtain parts inventory on a
favorable basis without committing its capital to purchasing inventory. In the fourth quarter
of 1999, the company realized a 35% increase in earnings as a result of selling surplus BOE-

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