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Intermediate Accounting
Chapter 1
Conceptual Framework for
Financial Reporting
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Overview of the Conceptual
Framework
• First Level = Objective of Financial Reporting
• Second Level = Qualitative Characteristics and Elements
• Third Level = Recognition, Measurement, and
Disclosure Concepts
LO 1 2

Overview
of the
Conceptual
Framework
chart
LO 1 3

Conceptual Framework
Basic Objective
To provide financial information about the reporting
entity that is useful to present and potential equity
investors, lenders, and other creditors in making
decisions about providing resources to the entity.
LO 1 4

Review Question
What are the Statements of Financial Accounting Concepts
intended to establish?
a. Generally accepted accounting principles in financial
reporting by business enterprises.
b. The meaning of “Present fairly in accordance with generally
accepted accounting principles.”
c. The objectives and concepts for use in developing standards
of financial accounting and reporting.
d. The hierarchy of sources of generally accepted accounting
principles.
LO 1 5

Review Question Answer
What are the Statements of Financial Accounting Concepts
intended to establish?
a. Generally accepted accounting principles in financial reporting
by business enterprises.
b. The meaning of “Present fairly in accordance with generally
accepted accounting principles.”
c. Answer: The objectives and concepts for use in developing
standards of financial accounting and reporting.
d. The hierarchy of sources of generally accepted accounting
principles.
LO 1 6

Identify the Qualitative Characteristics
of Accounting Information and the
Basic Elements of Financial Statements
7

Fundamental Concepts
Qualitative Characteristics of Accounting Information
“The FASB identified the qualitative characteristics of
accounting information that distinguish better (more
useful) information from inferior (less useful) information
for decision-making purposes.”
8
LO 2

Qualitative Characteristics
LO 2 9

Fundamental Quality—Relevance (2 of 5)
To have relevance, accounting information must be capable of
making a difference in a decision.
LO 2 10

Financial information has predictive value if it has value as an input
to predictive processes used by investors to form their own
expectations about the future.
LO 2 11

Relevant information also helps users confirm or correct prior
expectations.
LO 2 12

Information is material if omitting it or misstating it could
influence decisions that users make on the basis of the reported
financial information.
LO 2 13

Faithful Representation (2 of 5)
Faithful representation means that the numbers and descriptions
match what really existed or happened.
LO 2 14

Completeness means that all the information that is necessary for
faithful representation is provided.
LO 2 15

Neutrality means that a company cannot select information to
favor one set of interested parties over another.
LO 2 16

An information item that is free from error will be a more accurate
(faithful) representation of a financial item.
LO 2 17

Enhancing Qualities (2 of 6)
Enhancing qualitative characteristics distinguish more-useful
information from less-useful information.
LO 2 18

Information that is measured and reported in a similar manner for
different companies is considered comparable.
LO 2 19

Verifiability occurs when independent measurers, using the same
methods, obtain similar results.
LO 2 20

Timeliness means having information available to decision-makers
before it loses its capacity to influence decisions.
LO 2 21

Understandability is the quality of information that lets reasonably
informed users see its significance.
LO 2 22

Basic Elements (2 of 6)
Assets. Probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events.
Liabilities. Probable future sacrifices of economic benefits
arising from present obligations of a particular entity to
transfer assets or provide services to other entities in the
future as a result of past transactions or events.
Equity. Residual interest in the assets of an entity that
remains after deducting its liabilities.
LO 2 23

Investments by Owners. Increases in net assets of a
particular enterprise resulting from transfers to it from
other entities of something of value to obtain or increase
ownership interests (or equity) in it.
Distributions to Owners. Decreases in net assets of a
particular enterprise resulting from transferring assets,
rendering services, or incurring liabilities by the
enterprise to owners.
LO 2 24

Comprehensive Income. Change in equity (net assets) of
an entity during a period from transactions and other
events and circumstances from nonowner sources.
LO 2 25

Chapter 2
Income Statement and Related
Information

Identify the Uses and Limitations of an
Income Statement
Usefulness
 Evaluate past performance of the company
 Provide a basis for predicting future performance
 Help assess the risk or uncertainty of achieving future
cash flows
LO 1 27

Income Statement
Limitations
 Companies omit items they cannot measure reliably
 Income numbers are affected by the accounting
methods employed
 Income measurement involves judgment
LO 1 28

Content and Format of the Income
Statement
Elements of the Income Statement (Revenues)
Revenues – Inflows or other enhancements of assets of an
entity or settlements of its liabilities during a period from
delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central
operations.
Examples include sales, fees, interest, dividends, and rents.
LO 2 29

Elements of the Income Statement (1 of 2)
 Expenses – Outflows or other using-up of assets or
incurrences of liabilities during a period from
delivering or producing goods, rendering services, or
carrying out other activities that constitute the entity’s
ongoing major or central operations.
 Examples include cost of goods sold, depreciation,
interest, rent, salaries and wages, and taxes.
LO 2 30

Elements of the Income Statement (2 of 2)
 Gains – Increases in equity (net assets) from peripheral or
incidental transactions of an entity except those that result from
revenues or investments by owners.
 Losses – Decreases in equity (net assets) from peripheral or
incidental transactions of an entity except those that result from
expenses or distributions to owners.
 Gains and losses result from
 the sale of investments or plant assets,
 settlement of liabilities, and
 write-offs of assets due to impairments or
casualty.
LO 2 31

 The distinctions between revenues and gains, and between
expenses and losses, depend to a great extent on the typical
activities of the company.
 For example, when McDonald’s sells a hamburger, it
records the selling price as revenue. However, when
McDonald’s sells land, it records any excess of the selling
price over the book value as a gain.
 This difference in treatment results because the sale of the
hamburger is part of McDonald’s regular operations.
 The sale of land is not.
LO 2 32
Difference between revenue and gain and
expenses and losses

Components of the Income Statement
Multiple-Step Income Statement
 Separates operating transactions from nonoperating
transactions
 Matches costs and expenses with related revenues
 Highlights certain intermediate components of income
that analysts use assessing financial performance
LO 2 33

Intermediate Components
 Common to present some or all of the following
sections and totals within the income statement.
1. Operating section
2. Non operating section
3. Income tax
4. Discontinued operations
5. Non controlling interest
6. Earnings per share
LO 2 34

 Common to present some or all of the following sections and totals
within the income statement.
1. Operating section A report of the revenues and expenses of the
company’s principal operations.
I. Sales or Revenue. A subsection presenting sales, discounts,
allowances, returns, and other related information. Its purpose is to
arrive at the net amount of sales revenue.
II. Cost of Goods Sold. A subsection that shows the cost of goods that
were sold to produce the sales.
III. Selling Expenses. A subsection that lists expenses resulting from
the company’s efforts to make sales.
IV. Administrative or General Expenses. A subsection reporting
expenses of general administration.
LO 2 35

1. Non operating Section. A report of revenues and expenses
resulting from secondary or auxiliary activities of the
company. In addition, special gains and losses that are
infrequent or unusual, or both, are normally reported in this
section.
 Generally these items break down into two main
subsections:
I. Other Revenues and Gains. A list of the revenues
recognized or gains incurred, generally net of related
expenses, from non operating transactions.
II. Other Expenses and Losses. A list of the expenses or losses
incurred, generally net of any related incomes, from non
operating transactions.
LO 2 36

1. Income Tax. A section reporting federal and state taxes
levied on income from continuing operations.
2. Discontinued Operations. Material gains or losses
resulting from the disposition of a component of the
business.
3. Non controlling Interest. Allocation of income to non
controlling shareholders.
4. Earnings Per Share. A measure of performance over
the reporting period.
LO 2 37

Multiple-Step Income Statement
XYZ COMPANY
Income Statement
For The Year Ended December 31, 2020
LO 2 38

Condensed Income Statements
Cabrera Company
Income Statement
For the Year Ended December 31, 2020
Net sales………………………………………………… …………… $2,972,413
Cost of goods sold……………………………………….. ………………… 1,982,541
Gross profit…………………………………………….. 989,872
Selling expenses (see Note D)……………………………… ………$453,028
Administrative expenses…………………………………….. …… 350,771 803,799
Income from operations…………………………………… ………………… 186,073
Other revenues and gains…………………………………… ………………… 171,410
357,483
Other expenses and losses…………………………………… …………… 126,060
Income before income tax………………………………….. …………… 231,423
Income tax………………………………………………… …………. 66,934
Net income for the year………………………………………. …………… $ 164,489
Earnings per common share……………………………… ………….. $1.74
LO 2 39

Single-Step Income Statements
 No implication that one type of revenue or expense item has priority over
another.
LO 2 40

Income Statement
Exercise: Prepare a income statement for P. Bride Company from the data below
using the multiple-step form.
Administrative expense
Officers’ salaries $4,900
Depreciation of office furniture and equipment 3,960
Cost of goods sold 60,570
Rent revenue 17,230
Selling expense
Delivery expense 2,690
Sales commissions 7,980
Depreciation of sales equipment 6,480
Sales revenue 96,500
Income tax 9,070
Interest expense 1,860
LO 2 41

Sales revenue $96,500
Gross profit 35,930
Operating expenses:
Selling expense 17,150
Administrative expense 8,860
Total operating expenses 26,010
Income from operations 9,920
Other revenue (expense):
Rent revenue 17,230
Interest expense (1,860)
Total other 15,370
Income before tax 25,290
Income tax 9,070
Net income $16,220
LO 2 42
P. Bride Company
Income Statement

Reporting Various Income Items
 Companies are required to report additional items as part of
net income so users can better determine the long-run
earning power of the company.
 These income items fall into four general categories:
1. Unusual and infrequent gains and losses
2. Discontinued operations
3. Non controlling interest
4. Earnings per share
Modified all-inclusive concept
LO 3 43

Unusual and Infrequent Gains and Losses
a. Unusual. High degree of abnormality and of a type
clearly unrelated to, or only incidentally related to, the
ordinary and typical activities of the company, taking
into account the environment in which it operates.
b. Infrequency of occurrence. Type of transaction that is
not reasonably expected to recur in the foreseeable
future, taking into account the environment in which
the company operates.
LO 3 44

Unusual and Infrequent Gains and Losses
 Common types of unusual or infrequent gains and
losses:
 Losses on write-down (impairment) of receivables;
inventories; property, plant, and equipment; goodwill
or other intangible assets
 Restructuring charges
 Gains and losses from sale or abandonment of
property, plant and equipment
 Effects of a strike
LO 3 45

Unusual and Infrequent Gains and Losses (
 Gains and losses on extinguishment (redemption) of debt
obligations.
 Gains and losses related to casualties such as fires, floods,
and earthquakes.
 Gains or losses on sale of investment securities.
LO 3 46

Discontinued Operations
Occurs when two things happen:
1. A company eliminates the results of operations of a
component of the business.
2. The elimination of a component that represents a
strategic shift, having a major effect on the company’s
operations and financial results.
A strategic shift generally includes the disposal of
 (1) a major line of business, (2) a major geographical
area, or (3) a major equity method investment.
Amounts are reported “net of tax.”
LO 3 47

 Illustration: Multiplex Products Inc., a highly
diversified company, decides to discontinue its
electronics division.
 During the current year, the electronics division lost
$300,000 (net of tax).
 Multiplex Products sold the division at the end of the
year at a loss of $500,000 (net of tax).
 Multiplex determines that the electronics division
discontinuation meets the strategic shift criteria
 Because the division is a major line of business (its
assets exceed 20 percent of Multiplex’s total assets).
LO 3 48

Illustration: The following illustration shows how the discontinued
operations would be reported on the income statement for Multiplex
Products.
Income from continuing operations $20,000,000
Discontinued operations
Loss from operation of discontinued electronics
division (net of tax)
$300,000
Loss from disposal of electronics division (net of tax) 500,000 (800,000)
Net income $19,200,000
LO 3 49

 Discontinued
Operations are reported
after “Income from
continuing operations.”
 Without any
discontinued operations,
“Income from
continuing operations”
would be “net income.”
LO 3 50

Intraperiod Tax Allocation
 Allocation of tax within a period
 Helps users understand impact of income taxes on various
components of net income
 Intraperiod tax allocation is used for:
1. income from continuing operations
2. discontinued operations
LO 3 51

Discontinued Operations (Gain)
Illustration: Schindler Co. has income before income tax of
$250,000. It has a gain of $100,000 from a discontinued operation.
Assuming a 30 percent income tax rate, Schindler presents the
following information on the income statement.
Income before income tax $250,000
Income tax 75,000
Income from continuing operations 175,000
Gain on discontinued operations $100,000
Less: Applicable income tax 30,000 70,000
Net income $245,000
LO 3 52

Discontinued Operations (Loss)
Illustration: Schindler Co. has income before income tax of
$250,000. It suffers a loss from discontinued operations of
$100,000. Assuming a 30 percent tax rate, Schindler presents the
income tax on the income statement as shown
Income before income tax $250,000
Income tax 75,000
Income from continuing operations 175,000
Loss from discontinued operations $100,000
Less: Applicable income tax reduction 30,000 70,000
Net income $105,000
LO 3 53

Noncontrolling Interest in Income
 When a company owns substantial interests (generally
greater than 50%) in another company, GAAP
generally require that the financial statements of both
companies be consolidated together into one set of
financials.
 Noncontrolling interest is the portion of equity (net
assets) interest in a subsidiary not attributable to the
parent company.
LO 3 54

Noncontrolling Interest in Income
Illustration: Assume that Coca-Cola acquires 70 percent of the
outstanding stock of Koch Company. Because Coca-Cola owns
more than 50 percent of Koch, it consolidates Koch’s financial
results with its own. GAAP requires that net income be allocated to
the controlling and noncontrolling interest.
LO 3 55

Earnings per Share
NetIncome PreferredDividends
WeightedAverageof CommonSharesOutstanding

 A significant business indicator
 Measures the dollars earned by each share of common
stock
 Must be disclosed on the income statement
LO 3 56

Earnings per Share
Illustration: Lancer, Inc. reports net income of $350,000. It
declares and pays preferred dividends of $50,000 for the year.
The weighted-average number of common shares outstanding
during the year is 100,000 shares. Lancer computes earnings
per share as follows:
 e
NetIncome PreferredDividends
Weighted-Averageof CommonSharesOutstand
Earnings
in
per
g
Shar

3
$350,000 $50,000
100,000
$


LO 3 57

Earnings per Share
Poquito Industries Inc.
Income Statement (partial)
For the year Ended December 31, 2020
Income from continuing operations $276,000
Discontinued operations
Income from operations of Pizza Division, less
applicable income tax of $24,800 $54,000
Loss on disposal of Pizza Division, less
applicable income tax of $41,000 90,000 36,000
Net income $240,000
Per share of common stock
Income from continuing operations $2.76
Income from operations of discontinued division, net of tax 0.54
Loss on disposal of discontinued operation, net of tax 0.90
Net income $2.40
LO 3 58

Accounting Changes and Errors
Changes in Accounting Principle
 Changes in accounting occur frequently in practice
because important events or conditions may be in
dispute or uncertain at the statement date.
 One type of accounting change results when a
company adopts a different accounting principle.
 Changes in accounting principle include
 a change in the method of inventory pricing from
FIFO to average-cost, or
 a change in accounting for construction contracts
from the percentage-of-completion to the
completed-contract method.
LO 4 59

 A company recognizes a change in accounting
principle by making a retrospective adjustment to
the financial statements. Such an adjustment recasts
the prior years’ statements on a basis consistent with
the newly adopted principle.
 The company records the cumulative effect of the
change for prior periods as an adjustment to
beginning retained earnings of the earliest year
presented
LO 4 60

Illustration: Gaubert Inc. decided in March 2020 to change
from FIFO to weighted-average inventory pricing. Gaubert’s
income before taxes, using the new weighted-average method in
2020, is $30,000. This illustration presents the pretax income
data for 2018 and 2019 for this example.
Year FIFO
Weighted-
Average Method
Excess of FIFO over Weighted-
Average Method
2018 $40,000 $35,000 $5,000
2019 30,000 27,000 3,000
Total $8,000
LO 4 61

Changes in Accounting Principle Illustration 2
Illustration: Gaubert Inc. decided in March 2020 to change from
FIFO to weighted-average inventory pricing. Gaubert’s income
before taxes, using the new weighted-average method in 2020, is
$30,000. This illustration shows the information Gaubert
presented in its comparative income statements, based on a 30
percent tax rate.
2020 2019 2018
Income before income tax $30,000 $27,000 $35,000
Income tax 9,000 8,100 10,500
Net income $21,000 $18,900 $24,500
LO 4 62

Change in Accounting Estimates
 Changes in accounting estimates are inherent in the
accounting process.
 For example, companies estimate useful lives and salvage
values of depreciable assets, allowance for uncollectible
receivables, inventory obsolescence, and the number of
periods expected to benefit from a particular expenditure.
 A company accounts for such changes in estimates in the
period of change if they affect only that period, or in the
period of change and future periods if the change affects
both
LO 4 63

Change in Accounting Estimate
 Illustration: Arcadia H S, purchased equipment for
$510,000 which was estimated to have a useful life of 10
years with a salvage value of $10,000 at the end of that
time.
 Depreciation has been recorded for 7 years on a straight-
line basis. In 2020 (year 8), it is determined that the total
estimated life should be 15 years with a salvage value of
$5,000 at the end of that time.
Questions:
• What is the entry to correct prior years’ depreciation?
• Calculate the depreciation expense for 20 20.
LO 4 64

Calculation of depreciation for first 7 years.
Equipment cost $510,000
Salvage value − 10,000
Depreciable base 500,000
Useful life (original) ÷ 10 years
Annual depreciation $ 50,000
× 7 years = $350,000
After 7
years
Balance Sheet (December 31, 2019)
Fixed Assets:
Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000
LO 4 65

Calculate depreciation expense for 2020 and remaining years.
Net book value $160,000
Salvage value (revised) − 5,000
Depreciable base 155,000
Useful life ÷ 8 years
Annual expense $ 19,375
Journal entry for 2020 and remaining years.
Depreciation Expense 19,375
Accumulated Depreciation 19,375
LO 4 66

Accounting Errors
Corrections of Errors
 Errors occur as a result of mathematical mistakes, mistakes
in the application of accounting principles, or oversight or
misuse of facts that existed at the time financial statements
were prepared.
 In recent years, many companies have corrected for errors
in their financial statements.
 Companies correct errors by making proper entries in the
accounts and reporting the corrections in the financial
statements.
LO 4 67

Accounting Errors
Corrections of Errors
 Corrections of errors are treated as prior period adjustments,
similar to changes in accounting principles.
 Companies record a correction of an error in the year in
which it is discovered.
 They report the error in the financial statements as an
adjustment to the beginning balance of retained earnings.
 If a company prepares comparative financial statements, it
should restate the prior statements for the effects of the error.
LO 4 68

Accounting Errors
Illustration: In 2021, Hillsboro Co. determined that it
incorrectly overstated its accounts receivable and sales
revenue by $100,000 in 2020. In 2021, Hillboro makes the
following entry to correct for this error (ignore income
taxes).
Retained Earnings 100,000
Accounts Receivable 100,000
LO 4 69

Comprehensive Income
 Companies generally include in net income all revenues,
expenses, gains, and losses recognized during the period.
 Changes in accounting principles and corrections of errors
are excluded from the calculation of net income because
their effects relate to prior periods.
 The aggregate amount of the other comprehensive income
item is reported in stockholders’ equity as Accumulated Other
Comprehensive Income.
 One example is unrealized gains and losses on available-for-
sale debt investments. These gains and losses are excluded
from net income, thereby reducing volatility in net income
due to fluctuations in fair value.
LO 5 70

 Companies include these items that bypass the income statement in
a measure called comprehensive income.
 Comprehensive income includes all changes in equity during a
period except those resulting from investments by owners and
distributions to owners.
 Comprehensive income, therefore, includes the following: all
revenues and gains, expenses and losses reported in net income,
and all gains and losses that bypass net income but affect
stockholders’ equity.
 Example
 Unrealized gains and losses on available-for-sale securities
 Translation gains and losses on foreign currency
 Plus others
LO 5 71

 These items non-owner changes in equity that bypass the
income statement are referred to as other
comprehensive income and its presented in the
income statement section
 Companies must display the components of other
comprehensive income in one of two ways:
1. a single continuous statement (one statement
approach) or
2. two separate, but consecutive statements of net
income and other comprehensive income (two
statement approach)
LO 5 72

Review Question
Gains and losses that bypass net income but affect
stockholders' equity are referred to as
A. Comprehensive income.
B. Other comprehensive income.
C. Prior period income.
D. Unusual gains and losses.
LO 5 73

 Example illustrate these two alternatives in the next two
sections. In each case, assume that V. Gill Inc. reports the
following information for 2020: sales revenue $800,000, cost of
goods sold $600,000, operating expenses $90,000, and an
unrealized holding gain on available-for-sale debt investments
of $30,000, net of tax.
LO 5 74

Comprehensive Income (6 of 7)
One Statement Approach
Advantage - does
not require the
creation of a new
financial statement.
Disadvantage - net
income buried as a
subtotal on the
statement.
V. Gill Inc.
Statement of Comprehensive Income
Gross profit 200,000
Operating expenses 90,000
Net income 110,000
Other comprehensive income
Unrealized holding gain, net of tax 30,000
Comprehensive income $140,000
LO 5 75

Two Statement Approach
V. Gill Inc.
Income Statement
Gross Profit 200,000
Net income $110,000
V. Gill Inc.
Comprehensive Income Statement
Net income $110,000
Other comprehensive income
Unrealized holding gain, net of tax 30,000
Comprehensive income $140,000
LO 5 76

Statement of Stockholders’ Equity
• Reports changes in each stockholders’ equity account and
total stockholders' equity for the period
• Following items are disclosed in the statement:
• Contributions (issuances of shares) and distributions
(dividends) to owners
• Reconciliation of carrying amount of each component of
stockholders’ equity from beginning to end of period
LO 5 77

Statement of Stockholders’ Equity (chart)
V. Gill Inc.
Total
Retained
Earnings
Accumulated
Other
Comprehensive
Income
Common
Stock
Beginning balance $410,000 $ 50,000 $60,000 $300,000
Net income 110,000 110,000
Other comprehensive
income
Unrealized holding
gain, net of tax 30,000 30,000
Ending balance $550,000 $160,000 $90,000 $300,000
LO 5 78

Balance Sheet Presentation
V. Gill Inc.
Balance Sheet
As of December 31, 2020
(Stockholders’ Equity Section)
Stockholder’s equity
Common stock $300,000
Retained earnings 160,000
Accumulated other comprehensive income 90,000
Total stockholders’ equity $550,000
LO 5 79

Fundamentals of Revenue Recognition
 Recently, the FASB and IASB issued a converged
standard on revenue recognition entitled Revenue from
Contracts with Customers.
 To address the inconsistencies and weaknesses of the
previous approaches, a comprehensive revenue
recognition standard now applies to a wide range of
transactions and industries.
LO 1 80

New Revenue Recognition Standard
 Revenue from Contracts with Customers adopts
an asset-liability approach. Companies:
 Account for revenue based on the asset or liability
arising from contracts with customers.
 Are required to analyze contracts with customers
 Contracts indicate terms and measurement of
consideration.
 Contracts specify the promises that must be met
by each party.
LO 1 81

New Revenue Recognition Standard
Key Concepts of Revenue Recognition
Key Objective
Recognize revenue to depict the transfer of goods or services to customers in an
amount that reflects the consideration that the company receives, or expects to
receive, in exchange for these goods or services.
Five-Step Process for Revenue Recognition
1. Identify the contract with customers.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. Recognize revenue when each performance obligation is satisfied.
Revenue Recognition Principle
Recognize revenue in the accounting period when the
performance obligation is satisfied.
LO 1 82

Accounting for Revenue Recognition Issues
 Sales returns and allowances
 Repurchase agreements
 Bill and hold
 Principal-agent relationships
 Consignments
 Warranties
 Nonrefundable upfront fees
LO 3 83

Sales Returns and Allowances
 Right of return is granted for product for various
reasons (e.g., dissatisfaction with product).
 Company returning the product receives any
combination of the following.
1. Full or partial refund of any consideration paid.
2. Credit that can be applied against amounts owed,
or that will be owed, to the seller.
3. Another product in exchange.
LO 3 84

Credit Sales with Returns and Allowances
Illustration
On January 12, 2020, Venden Company sells 100 cameras for $100 each
on account to Amaya Inc. Venden allows Amaya to return any unused
cameras within 45 days of purchase. The cost of each product is $60.
Venden estimates that:
1. Three products will be returned.
2. The costs of recovering the products will be immaterial.
3. The returned products are expected to be resold at a profit.
On January 24, Amaya returns two of the cameras because they were the
wrong color. On January 31, Venden prepares financial statements and
determines that it is likely that only one more camera will be returned.
Venden makes the following entries related to these transactions.
LO 3 85

Credit Sales with Returns and Allowances-
January 12, 2020
Illustration: On January 12, 2020, Venden Company sells 100 cameras for $100
each on account to Amaya Inc. Venden allows Amaya to return any unused
cameras within 45 days of purchase. The cost of each product is $60. Venden
makes the following entries to record the sale of the cameras and related cost
of goods sold on January 12, 2020.
Sales Revenue (100 × $100) 10,000
Cost of Goods Sold 6,000
Inventory (100 × $60) 6,000
LO 3 86

January 24, 2020
Illustration: On January 12, 2020, Venden Company sells 100 cameras
for $100 each on account to Amaya Inc. Venden allows Amaya to return
any unused cameras within 45 days of purchase. The cost of each product
is $60. Venden makes the following entries to record the return of the
two cameras on January 24, 2020.
Sales Returns and Allowances 200
Accounts Receivable (2 × $100) 200
Returned Inventory 120
Cost of Goods Sold (2 × $60) 120
LO 3 87

January 31, 2020
Illustration: On January 31, 2020, Venden prepares financial statements. As
indicated earlier, Venden originally estimated that the most likely outcome was
that three cameras would be returned. Venden believes the original estimate is
correct and makes the following adjusting entries to account for expected returns
at January 31, 2020.
Allowance for Sales Returns and Allowances (1 × $100) 100
Estimated Inventory Returns 60
LO 3 88

Financial Statements
Venden’s income statement for the month ending of January 31, 2020.
Sales revenue (100 × $100) $10,000
Less: Sales returns and allowances ($200 + $100) 300
Net sales 9,700
Cost of goods sold (97 × $60) 5,820
Gross profit $ 3,880
Venden’s balance sheet as of January 31, 2020.
Accounts receivable ($10,000 − $200) $9,800
Less: Allowance for sales returns and allowances 100
Accounts receivable (net) $9,700
Returned inventory (including estimated) (3 × $60) $ 180
LO 3 89

Cash Sales with Returns and Allowances
Illustration: Assume now that Venden sold the cameras to Amaya for
cash instead of on account. In this situation, Venden makes the following
entries related to these transactions.
To record the sale of the cameras and related cost of goods sold on
January 12, 2020.
Cash 10,000
Sales Revenue (100 × $100) 10,000
Inventory (100 × $60) 6,000
LO 3 90

Cash Sales with Returns and Allowances –
January 24, 2020
Illustration: Assuming that Venden did not pay cash at the time of the
return of the two cameras to Amaya on January 24, 2020, the entries to
record the return of the two cameras and related cost of goods sold are as
follows.
Accounts Payable (2 × $100) 200
Returned Inventory 120
LO 3 91

Cash Sales with Returns and Allowances –
January 31, 2020
Illustration: On January 31, 2020, Venden prepares financial statements.
As indicated earlier, Venden estimates that the most likely outcome is that
one more camera will be returned. Venden therefore makes the following
adjusting entries.
Accounts Payable (1 × $100) 100
Estimated Inventory Returns 60
LO 3 92

Cash Sales with Returns and Allowances-
Financial Statements
Venden’s income statement for the month ending of January 31, 2020.
Sales revenue (100 × $100) $10,000
Less: Sales returns and allowances (3 × $100) 300
Net sales 9,700
Cost of goods sold (97 × $60) 5,820
Gross profit $ 3,880
Venden’s balance sheet as of January 31, 2020.
Cash (assuming no cash payments to date to Amaya) $10,000
Returned inventory (including estimated) (3 × $60) 180
Accounts payable ($200 + $100) 300
LO 3 93

Repurchase Agreements
 Companies enter into repurchase agreements, which allows
company to transfer an asset to a customer but have an
unconditional (forward) obligation or unconditional right (call
option) to repurchase the asset at a later date.
 In these situations, the question is whether the company sold the
asset.
 Generally, companies report these transactions as a financing
(borrowing).
 That is, if the company has a forward obligation or call option to
repurchase the asset for an amount greater than or equal to its
selling price, then the transaction is a financing transaction by
the company.
LO 3 94

Illustration
Facts: Morgan Inc., an equipment dealer, sells equipment on January 1,
2020, to Lane Company for $100,000. It agrees to repurchase this
equipment on December 31, 2021, for a price of $121,000.
Question: Should Morgan Inc. record a sale for this transaction?
Assuming an interest rate of 10 percent is imputed from the agreement,
Morgan makes the following entry to record the financing on January 1, 2020.
Cash 100,000
Liability to Lane Company 100,000
LO 3 95

Should Morgan Inc. record a scale for this transaction?
Morgan Inc. records interest on December 31, 2020, as follows.
Interest Expense 10,000
Liability to Lane Company ($100,000 × 10%) 10,000
Morgan Inc. records interest and retirement of its liability to Lane Company on
December 31, 2021, as follows.
Interest Expense 11,000
Liability to Lane Company ($110,000 × 10%) 11,000
Liability to Lane Company 121,000
Cash ($100,000 + $10,000 + $11,000) 121,000
LO 3 96

Bill-and-Hold Arrangements
 Contract under which an entity bills a customer for a product
but the entity retains physical possession of the product until
a point in time in the future.
 Result when buyer is not yet ready to take delivery but does
take title and accepts billing.
 Illustration Facts: Butler Company sells $450,000 (cost
$280,000) of fireplaces on March 1, 2020, to a local coffee
shop, Baristo, which is planning to expand its locations
around the city. Under the agreement, Baristo asks Butler to
retain these fireplaces in its warehouses until the new coffee
shops that will house the fireplaces are ready. Title passes to
Baristo at the time the agreement is signed.
LO 3 97

Question: When should Butler recognize the revenue from this bill-
and-hold arrangement?
Butler determines when it has satisfied its performance obligation to transfer a
product by evaluating when Baristo obtains control of that product.
For Baristo to have obtained control of a product in a bill-and-hold
arrangement, it must meet all of the conditions for change in control plus all of
the following criteria:
(a) The reason for the bill-and-hold arrangement must be substantive.
(b) The product must be identified separately as belonging to Baristo.
(c) The product currently must be ready for physical transfer to Baristo.
(d) Butler cannot have the ability to use the product or to direct it to another
customer.
In this case, it appears that the above criteria were met, and therefore revenue
recognition should be permitted at the time the contract is signed.
LO 3 98

When should Butler recognize the revenue from this bill-
and-hold arrangement?
Butler makes the following entry to record the sale on March 1, 2020.
Accounts receivable 450,000
Sales Revenue 450,000
Butler makes an entry to record the related cost of goods sold on March
1, 2020, as follows.
Inventory 280,000
LO 3 99

Principal-Agent Relationships
• Agent’s performance obligation is to arrange for principal to
provide goods or services to a customer.
• Examples:
• Preferred Travel Company (agent) facilitates booking of
cruise for Regency Cruise Company (principal).
• Priceline (agent) facilitates sale of various services such as
car rentals at Hertz (principal).
• Amounts collected on behalf of the principal are not revenue
of the agent.
• Revenue for agent is amount of commission received.
LO 3 100

Consignments
• Manufacturers (or wholesalers) deliver goods but retain
title to the goods until they are sold.
• Consignor (manufacturer or wholesaler) ships
merchandise to the consignee (dealer), who is to act as
an agent for the consignor in selling the merchandise.
• Consignor makes a profit on the sale.
• Carries merchandise as inventory.
• Consignee makes a commission on the sale.
LO 3 101

Long-Term Construction Contracts
Revenue Recognition Over Time
 A company satisfies a performance obligation and
recognizes revenue over time if at least one of the following
three criteria is met:
1. The customer simultaneously receives and consumes the
benefits of the seller’s performance as the seller performs.
2. The company’s performance creates or enhances an asset
(for example, work in process) that the customer controls as
the asset is created or enhanced; or
3. The company’s performance does not create an asset with an
alternative use.
LO 5 102

Revenue Recognition Over Time
Two Methods of Accounting:
Percentage-of-Completion Method
 Recognize revenues and gross profits each period
based upon the progress of the construction
 Buyer and seller have enforceable rights
Completed-Contract Method
 Recognize revenues and gross profit only when the
contract is completed
LO 5 103

Percentage-of-Completion Method
Revenue to Recognized Cost-to-Cost Basis
LO 5 104

Illustration
Hardhat Construction Company has a contract to construct a
$4,500,000 bridge at an estimated cost of $4,000,000. The
contract is to start in July 2020, and the bridge is to be
completed in October 2022. The following data pertain to the
construction period.
Blank 2020 2021 2022
Costs to date $1,000,000 $2,916,000 $4,050,000
Estimated costs to complete 3,000,000 1,134,000 -
Progress billings during the year 900,000 2,400,000 1,200,000
Cash collected during the year 750,000 1,750,000 2,000,000
LO 5 105

Application of Percentage-of-Completion Method,
Cost-to-Cost Basis
2020 2021 2022
Contract price $4,500,000 $4,500,000 $ 4,500,000
Less estimated cost:
Costs to date 1,000,000 2,916,000 4,050,000
Estimated costs to complete 3,000,000 1,134,000 —
Estimated total costs 4,000,000 4,050,000 4,050,000
Estimated total gross profit $ 500,000 $ 450,000 $ 450,000
Percent complete
25%
$1,000,000
$4,000,000
 
 
 
72%
$2,916,000
$4,050,000
 
 
 
100%
$4,050,000
$4,050,000
 
 
 
LO 5 106

Journal Entries—Percentage-of-Completion Method,
Cost-to-Cost Basis
LO 5 107

Percentage-of-Completion Revenue, Costs, and Gross
Profit by Year
To Date
Recognized in
Prior Years
Recognized in
Current Year
2020
Revenues ($4,500,000 × .25) $1,125,000 $1,125,000
Costs 1,000,000 1,000,000
Gross profit $ 125,000 $ 125,000
2021
Revenues ($4,500,000 × .72) $3,240,000 $1,125,000 $2,115,000
Costs 2,916,000 1,000,000 1,916,000
Gross profit $ 324,000 $ 125,000 $ 199,000
2022
Revenues ($4,500,000 × 1.00) $4,500,000 $3,240,000 $1,260,000
Costs 4,050,000 2,916,000 1,134,000
Gross profit $ 450,000 $ 324,000 $ 126,000
LO 5 108

Journal Entries to Recognize Revenue and Gross Profit and to Record
Contract Completion—Percentage-of-Completion Method, Cost-to-Cost
Basis
LO 5 109

Content of Construction in Process Account—Percentage-of-
Completion Method
LO 5 110

Financial Statement Presentation—Percentage-
of-Completion
Computation of Unbilled Contract Price at 12/31/20
Contract revenue recognized to date: $1,125,000
Billings to date (900,000)
Unbilled revenue $ 225,000
$1,000,000
$4,500,000
$4,000,000

LO 5 111

Financial Statement Presentation—
Percentage-of-Completion (2020)
LO 5 112

 Companies recognize revenue and gross profit
only at point of sale—that is, when the contract
is completed.
 Under this method, companies accumulate costs
of long-term contracts in process, but they make
no interim charges or credits to income statement
accounts for revenues, costs, or gross profit.
LO 6 113

Illustration
Under the completed-contract method for the bridge project
previously illustrated, Hardhat Construction Company would make
the following entries in 2022 to recognize revenue and costs and to
close out the inventory and billing accounts.
Billings on Construction in Process 4,500,000
Revenue from Long-Term Contracts 4,500,000
Costs of Construction 4,050,000
Construction in Process 4,050,000
LO 6 114

Comparison of Gross Profit Recognized under Different
Methods
Percentage-of-Completion Completed-Contract
2020 $125,000 $ 0
2021 199,000 0
2022 126,000 450,000
LO 6 115

Financial Statement Presentation
LO 6 116

Revenue Recognition for Franchises
Four types of franchising arrangements have evolved:
1. Manufacturer-retailer
2. Manufacturer-wholesaler
3. Service sponsor-retailer
4. Wholesaler-retailer
LO 8 117

Two Sources of Revenue
1. Sale of initial franchises and related assets or services, and
2. Continuing fees based on the operations of franchises.
LO 8 118

Franchises
The franchisor normally provides the franchisee with:
1. Assistance in site selection
2. Evaluation of potential income
3. Supervision of construction activity
4. Assistance in the acquisition of signs, fixtures, and equipment
5. Bookkeeping and advisory services
6. Employee and management training
7. Quality control
8. Advertising and promotion
LO 8 119

Franchise Accounting
Performance obligations relate to:
• Right to open a business
• Use of trade name or other intellectual property of the
franchisor
• Continuing services, such as marketing help, training, and in
some cases supplying inventory and inventory management
LO 8 120

Franchisors commonly charge an initial franchise fee and
continuing franchise fees:
• Initial franchise fee (payment for establishing the relationship
and providing some initial services)
• Continuing franchise fees received
• In return for continuing rights granted by the agreement
• For providing management training, advertising and
promotion, legal assistance, and other support
LO 8 121

Facts: Tum’s Pizza Inc. enters into a franchise agreement on December 31, 2020, giving
Food Fight Corp. the right to operate as a franchisee of Tum’s Pizza for 5 years. Tum’s
charges Food Fight an initial franchise fee of $50,000 for the right to operate as a
franchisee. Of this amount, $20,000 is payable when Food Fight signs the agreement, and
the note balance is payable in five annual payments of $6,000 each on December 31. As
part of the arrangement, Tum’s helps locate the site, negotiate the lease or purchase of
the site, supervise the construction activity, and provide employee training and the
equipment necessary to be a distributor of its products. Similar training services and
equipment are sold separately. Food Fight also promises to pay ongoing royalty payments
of 1% of its annual sales (payable each January 31 of the following year) and is obliged to
purchase products from Tum’s at its current standalone selling prices at the time of
purchase. The credit rating of Food Fight indicates that money can be borrowed at 8%.
The present value of an ordinary annuity of five annual receipts of $6,000 each
discounted at 8% is $23,957. The discount of $6,043 represents the interest revenue to be
accrued by Tum’s over the payment period.
LO 8 122

What are the performance obligations in this
arrangement and the point in time at which the
performance obligations for Tum’s are satisfied and
revenue is recognized?
Rights to the trade name, market area, and proprietary know-how for 5
years are not individually distinct.
• Each one is not sold separately and cannot be used with other goods
or services that are readily available to the franchisee.
• Combined rights give rise to a single performance obligation.
• Tum’s satisfies performance obligation at point in time when Food
Fight obtains control of the rights.
LO 8 123

What are the performance obligations in this
arrangement and the point in time at which the
performance obligations for Tum’s are satisfied and
revenue is recognized? (continued)
Training services and equipment are distinct because similar services and
equipment are sold separately.
• Tum’s satisfies those performance obligations when it transfers the
services and equipment to Food Fight.
Tum’s cannot recognize revenue for the royalty payments because it is
not reasonably assured to be entitled to those royalty amounts.
• Tum’s recognizes revenue for the royalties when (or as) the uncertainty
is resolved.
LO 8 124

Allocation of Transaction Price at December 31, 2020.
Rights to the trade name, market area, and proprietary know-how $20,000
Training services 9,957
Equipment (cost of $10,000) 14,000
Total transaction price $43,957
Training is completed January 2021, the equipment is
installed in January 2021, and Food Fight holds a grand
opening on February 2, 2021.
LO 8 125

Franchise Entry—Inception
Tum’s signs the agreement and receives upfront payment and note
on December 31, 2020
Cash 20,000
Notes Receivable 30,000
Discount on Notes Receivable 6,043
Unearned Franchise Revenue 20,000
Unearned Service Revenue (training) 9,957
Unearned Sales Revenue (equipment) 14,000
LO 8 126

Franchise Entries—Commencement of Operations
On February 2, 2021, franchise opens. Tum’s satisfies the
performance obligations related to the franchise rights, training,
and equipment.
Unearned Franchise Revenue 20,000
Franchise Revenue 20,000
Unearned Service Revenue (training) 9,957
Service Revenue (training) 9,957
Unearned Sales Revenue (equipment) 14,000
Sales Revenue 14,000
Inventory 10,000
LO 8 127

Franchise Entries—First Year of Franchise Operations
During 2021, Food Fight does well, recording $525,000 of sales in its first
year of operations. Tum’s records continuing franchise fees on December
31, 2021 as follows.
Accounts Receivable ($525,000 × 1%) 5,250
Franchise Revenue 5,250
To record payment received and interest revenue on note on December
31, 2021.
Cash 6,000
Notes Receivable 6,000
Discount on Notes Receivable 1,917
Interest Revenue ($23,957 × 8%) 1,917
LO 8 128

Explain the Purpose, Content, and
Preparation of the Statement of Cash Flows
129
Chapter three

Purpose of the Statement of Cash
Flows
To provide relevant information about the cash receipts and
cash payments of an enterprise during a period.
The statement provides answers to the following questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?
LO 3 130

Content of the Statement of Cash Flows
Three different activities:
1. Operating activities involve the cash effects of
transactions that enter into the determination of net
income.
2. Investing activities include making and collecting loans
and acquiring and disposing of investments and
property, plant, and equipment.
3. Financing activities involve liability and owners’ equity
items.
LO 3 131

Content of the Statement of Cash Flows
Basic Format of Cash Flow Statement
Statement of Cash Flows
Cash flows from operating activities $XXX
Cash flows from investing activities XXX
Cash flows from financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of year XXX
Cash at end of year $XXX
LO 3 132

Cash Inflows and Outflows
LO 3 133

Preparation of the Statement of Cash
Flows
Sources of Information
Information obtained from several sources:
1. comparative balance sheets,
2. the current income statement, and
3. selected transaction data.
LO 3 134

Preparation of the Statement of Cash
Flows Illustration
On January 1, 2020, in its first year of operations,
Telemarketing Inc. issued 50,000 shares of $1 par value
common stock for $50,000 cash. The company rented its
office space, furniture, and telecommunications equipment
and performed marketing services throughout the first year.
In June 2020, the company purchased land for $15,000. The
following illustration shows the company’s comparative
balance sheets at the beginning and end of 2020.
LO 3 135

Statement of Cash Flows Illustration
Comparative Balance Sheets
Telemarketing Inc.
Balance Sheets
Dec. 31, 2020 Jan. 1, 2020 Increase/Decrease
Assets
Cash $31,000 $-0- $31,000 Increase
Accounts receivable 41,000 -0- 41,000 Increase
Land 15,000 -0- 15,000 Increase
Total $87,000 $-0-
Liabilities and Stockholders' Equity
Accounts payable $12,000 $-0- 12,000 Increase
Common stock 50,000 -0- 50,000 Increase
Retained earnings 25,000 -0- 25,000 Increase
Total $87,000 $-0-
LO 3 136

Statement of Cash Flows Illustration (2 of 2)
Income Statement
Telemarketing Inc.
Income Statement
Revenues $172,000
Income before income tax 52,000
Income tax 13,000
Net income $ 39,000
Additional information:
Dividends of $14,000 were paid during the year.
LO 3 137

Preparing the Statement of Cash Flows
Four steps:
1. Determine the net cash provided by (or used in) operating
activities.
2. Determine the net cash provided by (or used in) investing
and financing activities.
3. Determine the change (increase or decrease) in cash
during the period.
4. Reconcile the change in cash with the beginning and the
ending cash balances.
LO 3 138

Cash Provided by Operating Activities
LO 3 139

Next, the company determines its investing and financing activities.
LO 3 140

Statement of Cash Flows (1 of 3)
Illustration
BE5.12 Keyser Beverage Company reported the following items in the
most recent year.
Net income $40,000
Dividends paid 5,000
Increase in accounts receivable 10,000
Increase in accounts payable 7,000
Purchase of equipment 8,000
Depreciation expense (capital expenditure) 4,000
Issue of notes payable 20,000
Required: Compute net cash provided by operating activities.
LO 3 141

Illustration
BE5.12 Compute net cash provided by operating activities.
Operating Activities
Net income $40,000
Depreciation expense 4,000
Increase in accounts receivable (10,000)
Net cash provided by operating activities 41,000
LO 3 142

Illustration
BE5.12 Keyser Beverage Company reported the following items in the
most recent year.
Net income $40,000
Dividends paid 5,000
Increase in accounts receivable 10,000
Purchase of equipment (capital expenditure) 8,000
Issue of notes payable 20,000
Required: Compute net change in cash during the year.
LO 3 143

BE5.12 Illustration
Operating Activities
Net income $40,000
Increase in accounts receivable (10,000)
Investing Activities
Purchase of equipment (8,000)
Financing Activities
Issue notes payable 20,000
Dividends paid (5,000)
Net cash flow from financing activities 15,000
Net increase in cash $48,000
LO 3 144

Review Question
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?
a. Sale of equipment at book value
b. Sale of merchandise on credit
c. Declaration of a cash dividend
d. Issuance of bonds payable at a discount.
LO 3 145

Review Question Answer
In preparing a statement of cash flows, which of the following
transactions would be considered an investing activity?
a. Answer: Sale of equipment at book value
b. Sale of merchandise on credit
c. Declaration of a cash dividend
d. Issuance of bonds payable at a discount.
LO 3 146

Significant Noncash Activities
Significant financing and investing activities that do not affect
cash are reported in either a separate schedule at the bottom
of the statement of cash flows or in the notes.
Examples include:
• Issuance of common stock to purchase assets
• Conversion of bonds into common stock
• Issuance of debt to purchase assets
• Exchanges of long-lived assets
LO 3 147

Comprehensive Statement of Cash Flows (1 of 2)
Nestor Company
Cash flows from operating activities
Net income $320,750
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense $ 88,400
Amortization of intangibles 16,300
Gain on sale of plant assets (8,700)
Increase in accounts receivable (net) (11,000)
Decrease in inventory 15,500
Decrease in accounts payable (9,500) 91,000
LO 3 148

Comprehensive Statement of Cash Flows (2 of 2)
Cash flows from investing activities
Sale of plant assets 90,500
Purchase of equipment (182,500)
Purchase of land (70,000)
Net cash used by investing activities (162,000)
Cash flows from financing activities
Payment of cash dividend (19,800)
Issuance of common stock 100,000
Redemption of bonds (50,000)
Net cash provided by financing activities 30,200
Net increase in cash 279,950
Cash at beginning of year 135,000
Cash at end of year $414,950
Noncash investing and financing activities
Purchase of equipment through issuance of $50,000 of bonds
LO 3 149

Chapter four
Cash and receivable

Indicate How to Report Cash and
Related Items
152
LO 1

Cash
• Most liquid asset
• Standard medium of exchange
• Basis for measuring and accounting for all items
• Current asset
• Examples: Coin, currency, available funds on deposit
at the bank, money orders, certified checks, cashier’s
checks, personal checks, bank drafts and savings
accounts
153
LO 1

Cash
Reporting Cash
Cash Equivalents
Short-term, highly liquid investments that are both
(a) readily convertible to cash, and
(b) so near their maturity that they present
insignificant risk of changes in value.
Examples: Treasury bills, Commercial paper, and Money
market funds.
154
LO 1

Summary of Cash-Related Items
Classification of Cash-Related Items
Item Classification Comment
Cash Cash If unrestricted, report as cash.
If restricted, identify and classify
as current and noncurrent assets.
Petty cash and change
funds
Cash Report as cash.
Short-term paper Cash equivalents Investments with maturity of less
than 3 months, often combined
with cash.
Short-term paper Temporary investments Investments with maturity of 3 to
12 months.
Postdated checks and lOU's Receivables Assumed to be collectible.
155
LO 1

Item Classification Comment
Travel advances Receivables Assumed to be collected from
employees or deducted from
their salaries.
Postage on hand (as stamps
or in postage meters)
Prepaid expenses May also be classified as office
supplies inventory.
Bank overdrafts Current liability If right of offset exists, reduce
cash.
Compensating balances Cash separately
classified as a deposit
maintained as
compensating balance
Classify as current or noncurrent
in the balance sheet. Disclose
separately in notes details of the
arrangement.
156
LO 1
Summary of Cash-Related Items
Classification of Cash-Related Items (continued)

Define Receivables and Explain
Accounting Issues Related to Their
Recognition
157
LO 2

Claims held against customers and others for money,
goods, or services.
Classified in the balance sheet as:
• Current or noncurrent
• Trade or nontrade
 Accounts receivable
 Notes receivable
158
Receivables
LO 2

Nontrade Receivables
1. Advances to officers and employees.
2. Advances to subsidiaries.
3. Deposits paid to cover potential damages or losses.
4. Deposits paid as a guarantee of performance or
payment.
5. Dividends and interest receivable.
6. Claims against: Insurance companies for casualties
sustained; defendants under suit; governmental bodies
for tax refunds; common carriers for damaged or lost
goods; creditors for returned, damaged, or lost goods;
customers for returnable items (crates, containers, etc.).
159
LO 2

160
Nontrade Receivables
Receivables Balance Sheet Presentations
LO 2

Recognition of Accounts Receivables
• Accounts receivable generally arise as part of a
revenue arrangement
• Revenue recognition principle indicates that a
company should recognize revenue when it satisfies
its performance obligation by transferring the good or
service to the customer.
161
LO 2

If Lululemon sells a yoga outfit to Jennifer Burian for $100 on
account, the yoga outfit is transferred when Jennifer obtains
control of this outfit. When this change in control occurs,
Lululemon should recognize an account receivable and sales
revenue. Lululemon makes the following entry:
Accounts Receivable 100
Sales Revenue 100
162
Recognition of Accounts Receivables
Illustration
LO 2

Valuation of Accounts Receivable (1 of 6)
• Record credit losses as debits to Bad Debt Expense
(or Uncollectible Accounts Expense)
• Normal and necessary risk of doing business on
credit
• Two methods to account for uncollectible accounts:
1. Direct write-off method
2. Allowance method
163
LO 3

Valuation of Accounts Receivable
Methods of Accounting for Uncollectible
Accounts
Direct Write-Off
• Theoretically deficient
• No matching
• Receivable not stated at
cash realizable value
• Not GAAP when material
in amount
Allowance Method
• Losses are estimated
• Percentage-of-sales
• Percentage-of-
receivables
• GAAP requires when
material in amount
164
LO 3

Direct Write-Off Method for Uncollectible
Accounts
When a company determines a particular account to be
uncollectible, it charges the loss to Bad Debt Expense.
Assume, for example, that on December 10 Cruz Co. writes off
as uncollectible Yusado’s $8,000 balance. The entry is:
Bad Debt Expense 8,000
Accounts Receivable (Yusado) 8,000
165
LO 3

• Involves estimating uncollectible accounts at end of
each period
• Ensures that companies state receivables on balance
sheet at net realizable value
• Companies estimate uncollectible accounts and net
realizable value using information about past and
current events as well as forecasts of future
collectibility
166
Allowance Method for Uncollectible Accounts
LO 3

Illustration: Assume that Brown Furniture in 2020, its first
year of operations, has credit sales of $1,800,000. Of this
amount, $150,000 remains uncollected at December 31. The
credit manager estimates that $10,000 of these sales will be
uncollectible. The adjusting entry to record the estimated
uncollectibles (assuming a zero balance in the allowance
account) is:
167
Allowance Method for Uncollectibles
Recording Estimated Uncollectibles
Allowance for Doubtful Accounts 10,000
LO 3

The amount of $140,000 represents the net realizable value of
the accounts receivable at the statement date.
168
Presentation of Allowance for Doubtful Accounts
LO 3

• When companies have exhausted all means of
collecting a past-due account and collection appears
impossible, the company should write off the
account
• In the credit card industry, for example, it is standard
practice to write off accounts that are 210 days past
due.
169
Recording the Write-Off of an Uncollectible
Account
LO 3

Recording the Write-Off of an
Uncollectible Account
Illustration: The financial vice president of Brown Furniture
authorizes a write-off of the $1,000 balance owed by Randall
Co. on March 1. The entry to record the write-off is:
170
LO 3

Assume that on July 1, Randall Co. pays the $1,000 amount
that Brown had written off on March 1. These are the entries:
Cash 1,000
171
LO 3

Percentage-of-Receivables Approach
• Reports estimate of receivables at realizable value
• Companies may apply this method using
 one composite rate, or
 an aging schedule using different rates
172
Estimating the Allowance
LO 3

173
LO 3

What entry
would Wilson
make assuming
that the
allowance
account had a
zero balance?
174
LO 3

Bad Debt Expense ($26,610 – $800) 25,810
175
What entry
would Wilson
make assuming
the allowance
account had a
credit balance of
$800 before
adjustment?
LO 3

Dr. Cr.
Accounts Receivable $100,000
Allowance for Doubtful Accounts $ 2,000
Sales Revenue (all on credit) 900,000
Sales Returns and Allowances 50,000
Ducan Company reports the following financial information before
adjustments.
Instructions: Prepare the journal entry to record Bad Debt Expense
assuming Duncan Company estimates bad debts at (a) 5% of accounts
receivable and (b) 5% of accounts receivable but Allowance for Doubtful
Accounts had a $1,500 debit balance.
176
Illustration
LO 3

assuming Duncan Company estimates bad debts at (a) 5% of accounts
receivable.
$100,000 × 5% = $5,000 − $2,000 = $3,000
177
Dr. Cr.
Illustration
LO 3

assuming Duncan Company estimates bad debts at (b) 5% of accounts
receivable but the Allowance had a $1,500 debit balance.
$100,000 × 5% = $5,000 + $1,500 = $6,500
178
Dr. Cr.
Illustration
LO 3

Explain Common Techniques Employed
to Control Cash
179
LO 6

Cash Controls
Management faces two problems in accounting for cash
transactions:
1. Establish proper controls to prevent any
unauthorized transactions by officers or employees.
2. Provide information necessary to properly manage
cash on hand and cash transactions.
180
LO 6

To obtain desired control objectives, a company can vary
the number and location of banks and the types of
accounts.
• Collection float
• Lockbox accounts
• General checking account
• Imprest bank accounts
181
Cash Controls
Using Bank Accounts
LO 6

To pay small amounts for miscellaneous expenses.
Steps:
1. Record $300 transfer of funds to petty cash:
Petty Cash 300
Cash 300
2. The petty cash custodian obtains signed receipts from
each individual to whom he or she pays cash.
182
Cash Controls
The Imprest Petty Cash System
LO 6

3. Custodian receives a company check to replenish the
fund.
Supplies Expense 42
Postage Expense 53
Miscellaneous Expense 76
Cash Over and Short 2
Cash 173
183
Cash Controls
Steps:
LO 6

184
Cash Controls
Steps:
4. If the company decides that the amount of cash in the
petty cash fund is excessive by $50, it lowers the fund
balance as follows.
Cash 50
Petty Cash 50
LO 6

Company should
• Minimize cash on hand
• Only have on hand petty cash and current day’s
receipts
• Keep funds in a vault, safe, or locked cash drawer
• Transmit each day’s receipts to the bank as soon as
practicable
• Periodically prove (reconcile) balance shown in
general ledger
185
Cash Controls
Physical Protection of Cash Balances
LO 6

Schedule explaining any differences between the bank’s
and the company’s records of cash.
Reconciling Items:
1. Deposits in transit.
2. Outstanding checks.
3. Bank charges and credits.
4. Bank or Depositor errors.
186
Cash Controls
Reconciliation of Bank Balances
LO 6

Bank Reconciliation Form
187
LO 6

Illustration: Nugget Mining Company’s books show a cash balance at the
Denver National Bank on November 30, 2020, of $20,502. The bank
statement covering the month of November shows an ending balance of
$22,190. An examination of Nugget’s accounting records and November
bank statement identified the following reconciling items.
1. A deposit of $3,680 that Nugget mailed November 30 does not
appear on the bank statement.
2. Checks written in November but not charged to the November bank
statement are:
Check #7327 $ 150
#7348 4,820
#7349 31
188
LO 6

Continued
3. Nugget has not yet recorded the $600 of interest collected by the bank
November 20 on Sequoia Co. bonds held by the bank for Nugget.
4. Bank service charges of $18 are not yet recorded on Nugget’s books.
5. The bank returned one of Nugget’s customer’s checks for $220 with the
bank statement, marked “NSF.” The bank treated this bad check as a
disbursement.
6. Nugget discovered that it incorrectly recorded check #7322, written in
November for $131 in payment of an account payable, as $311.
7. A check for Nugent Oil Co. in the amount of $175 that the bank
incorrectly charged to Nugget accompanied the statement.
189
LO 6

Journalize the adjusting entry on the books of Nugget Mining
Company at November 30.
Cash 542
Office Expense (Bank Charges) 18
Accounts Receivable 220
Accounts Payable 180
Interest Revenue 600
191
Journal Entries
LO 6

The reconciling item in a bank reconciliation that will
result in an adjusting entry by the depositor is:
a. outstanding checks.
b. deposit in transit.
c. a bank error.
d. bank service charges.
192
Cash Controls
Review Question
LO 6

The reconciling item in a bank reconciliation that will
result in an adjusting entry by the depositor is:
a. outstanding checks.
b. deposit in transit.
c. a bank error.
d. bank service charges.
193
Appendix 7A: Cash Controls
Review Question
LO 6

CHAPTER FIVE
Valuation of Inventories:
A Cost-Basis Approach

Identify Inventory Classifications and
Different Inventory Systems
LO 1 196

Inventory Issues
Classification
Inventories are:
• asset items held for sale in ordinary course of business, or
• goods to be used in production of goods to be sold
LO 1 197

Inventory Issues
Merchandising Company
Classification
• One inventory
account
• Purchase
merchandise in a
form ready for sale
LO 1 198

Inventory Issues
Manufacturing Company
Three accounts
• Raw Materials
• Work in Process
• Finished Goods
LO 1 199

Determine the Goods and Costs Included in
Inventory
LO 2 200

Goods and Costs Included in Inventory
Goods Included in Inventory
1. Goods owned & on hand
 A company recognizes inventory and accounts payable at the time it controls
the asset. For example, when XYZ co purchases Apple watches for resale,
XYZ records these watches as inventory at the time control passes to it.
 Control is therefore the key factor in determining when purchases and sales of
a product are recognized.
 Note that who owns the goods, as well as the costs to include in inventory, are
essentially accounted for the same under IFRS and GAAP.
2. Goods in Transit
 Goods purchased and in transit FOB Shipping Point (if company is the
buyer)
 Goods sold and in transit FOB Destination (if company is the seller)
LO 2 201

Goods in Transit
LO 2 202

Consigned Goods
 A common principal-agent relationship involves
consignments. In these cases, manufacturers (or
wholesalers) deliver goods but retain title to the goods
until they are sold.
 This specialized method of marketing certain types of
products makes use of an agreement known as a
consignment.
 Under this arrangement, the consignor (manufacturer or
wholesaler) ships merchandise to the consignee (dealer),
who is to act as an agent for the consignor in selling the
merchandise.
 Both consignor and consignee are interested in selling
 Consignor make a profit or develop a market,
 Consignee make a commission on the sale.
LO 2 203

3. Consigned Goods
 The consignee accepts the merchandise and agrees to
exercise due care and protection from loss or damage,
until it sells the goods to a third party.
 The consignee remits to the consignor cash received from
customers, after deducting a sales commission and any
chargeable expenses.
 The consignor carries the merchandise as inventory
throughout the consignment, separately classified as
Inventory (consignments) or
 Goods out on consignment remain the property of the
consignor
 The consignee does not record the merchandise as an
asset on its books.
 Revenue is then recognized by the consignor
LO 2 204

Special Sales Agreements
Sales with Repurchase Agreement
 Often referred to as a repurchase (or product
financing) agreement, usually involves a transfer
(sale) with either an implicit or explicit repurchase
agreement.
 These arrangements are often described in practice
as “parking transactions.”
 Goods sold with buyback or repurchase agreement –
Inventory of the seller.
LO 2 205

Special Sales Agreements
Sales with High Rates of Return
 Goods sold with refund orders
 If the seller can estimate future returns–
inventory of the Buyer
 If items are unpredictable – inventory of the
seller until the expiration of refund period.
Seller
1. Record sales revenue at the amount it expects to
receive from the transaction.
2. Establishes an estimated inventory return account
at the date of sale to recognize that some of its
inventory will be returned.
LO 2 206

Costs Included in Inventory
 Cost of Purchase
 Purchase price subject to Trade discount & Cash discount.
 If the perspective is that we are the buyer, and the term is FOB shipping
point, the freight charge is capitalized as cost of inventory.
 Import Duties and Irrevocable Purchase Taxes
 Exclude the VAT
 Handling and Other Cost Directly Attributable to the Acquisition.
 Cost of conversion
 Direct Labor + Overhead Other Cost
 Necessary to bring the inventories to their present location and
condition
 Purchase Discount Loss – part of other expenses in Income
Statement.
LO 2 207

Costs Included in Inventory
Cost of Item Excluded from Cost of Inventories
 Abnormal wastage
 Storage cost for Finished Goods (unless necessary for
production process before a further production stage)
 Administrative Overhead
 Selling Expense
 Interest Expense
 Goods held on consignment
 “Specifically segregated per sale contract”, if included in the
count, deduct the amount.
 Items in receiving department refused because of damage
 Items included in count, damaged and unsaleable “if
included, deduct”
LO 2 208

Describe and Compare the Cost Flow
Assumptions Used to Account for
Inventories
LO 3 209

Which Cost Flow Assumptions to
Adopt?
Specific Identification
versus
FIFO --- LIFO --- Average Cost
Cost Flow Assumption Adopted does NOT need to
be consistent with Physical Movement of Goods
Method adopted should be one that most clearly reflects
periodic income.
LO 3 210

Adopt?
Illustration
Call-Mart Inc. had the following transactions in its first month
of operations.
Date Purchased Sold or Issued Balance
March 2 2,000 @ $4.00 2,000 units
March 15 6,000 @ $4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000 @ $4.75 6,000 units
Calculate Goods Available for Sale.
LO 3 211

Adopt? (Continued)
Illustration
March 2 2,000 @ $4.00 2,000 units
March 15 6,000 @ $4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000 @ $4.75 6,000 units
Calculation
of Goods
Available
for Sale
Beginning inventory (2,000 × $4) $ 8,000
Purchases:
6,000 × $4.40 26,400
2,000 × 4.75 9,500
Goods available for sale $43,900
LO 3 212

Adopt?
• Includes in cost of goods sold the costs of specific items
sold
• Used when handling a relatively small number of costly,
easily distinguishable items
• Matches actual costs against actual revenue
• Cost flow matches physical flow of goods
• May allow a company to manipulate net income
LO 3 213

Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of the
following. Compute the amount of ending inventory and cost of
goods sold.
Date No. of Units Unit Cost Total Cost
March 2 1,000 $4.00 $ 4,000
March 15 3,000 4.40 13,200
March 30 2,000 4.75 9,500
Ending inventory 6,000 $26,700
Cost of goods available for sale
(computed in previous section) $43,900
Deduct: Ending inventory 26,700
Cost of goods sold $17,200
LO 3 214

Adopt?
Average-Cost
• Prices items in inventory on basis of average cost of all
similar goods available during the period
• Not subject to income manipulation
• Measuring a specific physical flow of inventory is often
impossible
LO 3 215

Average-Cost
Weighted-Average Method
Date of invoice No. Units Unit Cost Total Cost
March 2 2,000 $4.00 $ 8,000
March 15 6,000 4.40 26,400
March 30 2,000 4.75 9,500
Total goods available 10,000 $43,900
$43,900
Weighted-average cost per unit = $4.39
10,000
Inventory in units 6,000 units
Ending inventory 6,000 × $4.39 = $26,340
Cost of goods available for sale $43,900
LO 3 216

Average-Cost
Moving-Average Method
March 2 (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000
March 15 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400
March 19 (4,000 @ $4.30)
$17,200
(4,000 @ 4.30) 17,200
March 30 (2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700
In this method, Call-Mart computes a new average unit
cost each time it makes a purchase.
LO 3 217

Which Cost Flow Assumptions to Adopt?
First-In, First-Out (FIFO)
 Under this method companies cost of ending inventories
by taking the unit cost of the most recent purchase and
working backward until all unit have been assigned a
cost.
 Is the cost flow method which is parallels with actual
flow of merchandise.
 Assumes goods are used in order in which they are
purchased
 Approximates physical flow of goods
 Ending inventory is close to current cost
Fails to match current costs against current revenues
LO 3 218

Periodic Inventory System
Date No. Units Unit Cost Total Cost
March 30 2,000 $4.75 $ 9,500
March 15 4,000 4.40 17,600
Cost of goods available for sale $43,900
Determine cost of ending inventory by taking the cost of
the most recent purchase and working back until it
accounts for all units in the inventory.
LO 3 219

Perpetual Inventory System
In all cases where F I F O is used, the inventory and cost of
goods sold would be the same at the end of the month
whether a perpetual or periodic system is used.
LO 3 220

Last-In, First-Out (LIFO)
Periodic Inventory System
Date of Invoice No. Units Unit Cost Total Cost
March 2 2,000 $4.00 $ 8,000
March 15 4,000 4.40 17,600
Goods available for sale $43,900
The cost of the total quantity sold or issued during the month
comes from the most recent purchases.
LO 3 221

Last-In, First-Out (LIFO)
Perpetual Inventory System
The LIFO method results in different ending inventory and
cost of goods sold amounts than the amounts calculated
under the periodic method.
LO 3 222

Determine the Effects of Inventory Errors
on the Financial Statements
LO 4 223

Effects of Inventory Errors
Ending Inventory Misstated
Balance Income
Inventory Understated Cost of goods sold Overstated
Retained earnings Understated
Working capital Understated Net income Understated
Current ratio Understated
If ending inventory is understated, working capital
(current assets less current liabilities) and the current ratio
(current assets divided by current liabilities) are
understated. The effect of an error on net income in one
year will be counterbalanced in the next, however the
income statement will be misstated for both years.
224
LO 4

Illustration
To illustrate the effect on net income over a two-year
period (2019–2020), assume that Jay Weiseman Corp.
understates its ending inventory by $10,000 in 2019; all
other items are correctly stated. The effect of this error is
to decrease net income in 2019 and to increase net income
in 2020. The error is counterbalanced (offset) in 2020
because beginning inventory is understated and net income
is overstated.
The following illustration shows that the income statement
misstates the net income figures for both 2019 and 2020
although the total for the two years is correct.
225
LO 4

226
LO 4

Purchases and Inventory Misstated
Suppose that Bishop Company does not record as a purchase
certain goods that is owns and does not count them in ending
inventory.
Balance Sheet Income Statement
Inventory Understated Purchases Overstated
Retained earnings No effect Cost of goods sold No effect
Accounts payable Understated Net income No effect
Working capital No effect Inventory (ending) Understated
Current ratio Overstated
The understatement does not affect cost of goods sold and
net income because the errors offset one another.
227
LO 4

Purchases and Inventory Misstated
Illustration
Assume that Bishop
understated accounts
payable and ending
inventory by $40,000.
The following
illustrations shows the
understated and
correct data.
Purchases and Ending
Inventory Understated
Current assets $ 120,000
Current liabilities $ 40,000
Current ratio 3 to 1
Purchases and Ending
Inventory Correct
Current assets $160,000
Current liabilities $ 80,000
Current ratio 2 to 1
228
LO 4

Describe and Apply the Lower-of-Cost-
or-Net Realizable Value Rule
LO 5 230

Lower-of-Cost-or-Net Realizable Value
 Inventories are recorded at their cost.
 However, if inventory declines in value below its
original cost, a major departure from the historical cost
principle occurs.
 Whatever the reason for a decline damage, physical
deterioration, obsolescence, changes in price levels, or
other causes a company should write down the
inventory to net realizable value to report this loss.
Definition of Net Realizable Value
 Estimated selling price in the ordinary course of
business, less reasonably predictable costs of
completion, disposal, and transportation
231
LO 5

Illustration
Assume that Mander Corp. has unfinished inventory with
a cost of $950, a sales value of $1,000, estimated cost of
completion of $50, and estimated selling costs of $200.
Mander’s net realizable value is computed as follows.
Inventory value—unfinished $1,000
Less: Estimated cost of completion $ 50
Estimated cost to sell 200 250
Net realizable value $ 750
232
LO 5

LCNRV Disclosures
• Mander reports inventory at $750
• In its income statement, Mander reports a Loss Due to
Decline of Inventory to NRV of $200 ($950 − $750)
233
LO 5

Illustration of LCNRV
Determining Final Inventory Value – Regner Foods
Food Cost Net Realizable Value Final Inventory Value
Spinach $ 80,000 $120,000 $ 80,000
Carrots 100,000 100,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed Vegetables 95,000 92,000 92,000
$384,000
Final Inventory Value
Spinach Cost ($80,000) is selected because it is lower then net realizable value.
Carrots Cost ($100,000) is the same as net realizable value.
Cut beans Net realizable value ($40,000) is selected because it is lower than cost.
Peas Net realizable value ($72,000) is selected because it is lower than cost.
Mixed Vegetables Net realizable value ($92,000) is selected because it is lower than cost.
234
LO 5

Method of Applying LCNRV
Alternative Applications of LCNRV
Note NRV > COST use cost
NRV < COST use NRV
 Companies usually price inventory on an item-by-item basis.
235
LO 5

Recording NRV Instead of Cost
The following inventory data is for Ricardo Company.
Ending inventory (cost) $ 82,000
Ending inventory (at NRV) 70,000
Adjustment $ 12,000
Loss
Method
Loss Due to Decline in Inventory to NVR 12,000
Inventory 12,000
COGS
Method
Inventory 12,000
236
LO 5

Use of an Allowance
Instead of crediting the Inventory account for market
adjustments, companies generally use an allowance account,
often referred to as Allowance to Reduce Inventory to NRV.
Loss Due to Decline of Inventory to NRV 12,000
Allowance to Reduce Inventory to NRV 12,000
Presentation of Inventory Using an Allowance Account
Inventory (at cost) $ 82,000
Allowance to reduce inventory to NRV (12,000)
Inventory (at NRV) $ 70,000
237
LO 5

Balance Sheet
Loss
Method
COGS
Method
Current assets:
Cash $ 100,000 $ 100,000
Accounts receivable 350,000 350,000
Inventory 770,000 758,000
Less: Allowance to reduce inventory to NRV (12,000) 0
Prepaids 20,000 20,000
Total current assets $1,228,000 $1,228,000
238
LO 5

Income Statement
Loss Method COGS Method
Sales $ 300,000 $ 300,000
Cost of goods sold 120,000 132,000
Gross profit 180,000 168,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
239
LO 5

Recording NRV Instead of Cost (continued)
Income Statement
Loss Method COGS Method
Other revenue and (expense):
Loss on inventory (12,000) -
Interest income 5,000 5,000
Total other revenue and (expense) (7,000) 5,000
Income from operations 108,000 108,000
Income tax expense 32,400 32,400
Net income $ 75,600 $ 75,600
240
LO 5

Use of an Allowance—Multiple Periods
In general, accountants adjust the allowance account balance at
the next year-end to agree with the discrepancy between cost and
the L C N R V at that balance sheet date.
Date
Inventory
at Cost
Inventory at
NRV
Amount
Required in
Valuation
Account
Adjustment
of Valuation
Account
Balance
Effect on Net
Income
Dec. 31, 2016 $188,000 $176,000 $12,000 $12,000 inc. Decrease
Dec. 31, 2017 194,000 187,000 7,000 5,000 dec. Increase
Dec. 31, 2018 173,000 174,000 0 7,000 dec. Increase
Dec. 31, 2019 182,000 180,000 2,000 2,000 inc. Decrease
241
LO 5

Describe and Apply the Lower-of-Cost-
or-Market Rule
242
LO 6

Lower-of-Cost-or-Market
 The use of the lower-of-cost-or-net realizable value
method works well to measure the decline in value of
a company’s inventory for most companies.
 FASB granted an exception to the LCNRV approach
for companies that use the LIFO or retail inventory
methods.
 Rather than comparing cost to net realizable value
companies compare a “designated market value” of
inventory to cost
 This approach is commonly referred to as lower-of-
cost-or-market (LCM)
LO 6 243

Two Limitations
This approach begins with replacement cost, then applies two
additional limitations to value ending inventory.
• Net realizable value (ceiling)
• Net realizable value less a normal profit margin (floor)
LO 6 244

Net Realizable Value (NRV)
 NRV is the estimated selling price in the ordinary course of
business, less reasonably predictable costs of completion
and disposal.
 A company values inventory at the lower-of-cost-or-
market, with market limited to an amount that is not more
than net realizable value or less than net realizable
value less a normal profit margin.
 A normal prof t margin is subtracted from that amount to
arrive at net realizable value less a normal prof t margin.
LO 6 245

Illustration
Assume that Parker Corp. has unfinished inventory with a sales
value of $1,000, estimated cost of completion and disposal of
$300, and a normal profit margin of 10 percent of sales. Parker
determines the following net realizable value.
Inventory—sales value $ 1,000
Less: Estimated cost of completion and disposal 300
Net realizable value 700
Less: Allowance for normal profit margin (10% of sales) 100
Net realizable value less a normal profit margin $ 600
LO 6 246

Inventory Valuation
What is the rationale for the Ceiling and Floor
limitations?
LO 6 247

Rationale
What is the rationale for the Ceiling and Floor
limitations?
• Ceiling – prevents overstatement of the value of
obsolete, damaged, or shopworn inventories
• Floor – deters understatement of inventory and
overstatement of loss in current period
LO 6 248

How Lower-of-Cost-or-Market Works
Loss Due to Decline of Inventory to Market 65,000
Allowance to Reduce Inventory to Market 65,000
LO 6 249

Methods of Applying Lower-of-Cost-or-
Market
LO 6 250

Determine Ending Inventory by
Applying the Gross Profit Method
LO 8 251

Gross Profit Method of Estimating
Inventory
Substitute Measure to Approximate Inventory
1. Beginning inventory plus purchases equal total goods
to be accounted for.
2. Goods not sold must be on hand.
3. The sales, reduced to cost, deducted from the sum of
the opening inventory plus purchases, equal ending
inventory.
LO 8 252

Gross Profit Method
Illustration: Cetus Corp. has a beginning inventory of $60,000
and purchases of $200,000, both at cost. Sales at selling price
amount to $280,000. The gross profit on selling price is 30
percent. Cetus applies the gross margin method as follows.
Beginning inventory (at cost) $ 60,000
Purchases (at cost) 200,000
Goods available (at cost) 260,000
Sales (at selling price) 280,000
Less: Gross profit (30% of $280,000) 84,000
Sales (at cost) 196,000
Approximate inventory (at cost) $ 64,000
LO 8 253

Gross Profit Method
Computation of Gross Profit Percentage
Illustration: In the previous illustration, the gross profit was a
given. But how did Cetus derive that figure? To see how to
compute a gross profit percentage, assume that an article cost $15
and sells for $20, a gross profit of $5.
$5
$20
25%at retail
 
Markup
Retail
  t
$5
$1
1
33
5
% on cos
3
Markup
Cost
LO 8 254

Gross Profit Method
For example, assume that a company marks up a given item by 25
percent. What, then, is the gross prof t on selling price? To find the
answer, assume that the item sells for $1. In this case, the following
formula applies.
Cost + Gross profit = Selling price
C + .25C = SP
(1 + .25)C = SP
1.25C = $1.00
C = $0.80
The gross prof t equals $0.20 ($1.00 − $0.80). The rate of gross prof t
on selling price is therefore 20 percent ($0.20/$1.00).
LO 8 255

Gross Profit Method
 Conversely, assume that the gross prof t on selling price is 20
percent. What is the markup on cost? To find the answer, again
assume that the item sells for $1. Again, the same formula holds:
Cost + Gross prof t = Selling price
C + .20SP = SP
C = (1 − .20)SP
C = .80SP
C = .80($1.00)
C = $0.80
 As in the previous example, the markup equals $0.20 ($1.00 −
$0.80). The markup on cost is 25 percent ($0.20/$0.80)
LO 8 256

Gross Profit Method
Formulas
1. 
Percentage Markup on Cost
100
Gross Profit on
% +Percentage M
Selling Pri
arkup
ce
on Cost
2. 

GrossProfit onSellingPrice
100% GrossProfit onSellingPrice
Percentage Markup on Cost
LO 8 257

Gross Profit Method
Application of Gross Profit Formulas
LO 8 258

Gross Profit Method
Illustration
Astaire Company uses the gross profit method to estimate inventory for
monthly reporting purposes. Presented below is information for the
month of May.
Inventory, May 1 $ 160,000
Purchases (gross) 640,000
Freight-in 30,000
Sales 1,000,000
Sales returns 70,000
Purchase discounts 12,000
Compute the estimated inventory at May 31, assuming that the gross
profit is 25% of sales. Compute the estimated inventory at May 31,
assuming that the gross profit is 25% of cost.
LO 8 259

Gross Profit Method
Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.
Inventory, May 1 (at cost) $ 160,000
Purchase (gross) (at cost) 640,000
Purchase discounts (12,000)
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) $ 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less gross profit (25% of $930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) $ 120,500
LO 8 260

Gross Profit Method
Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.
LO 8 261

Gross Profit Method
Evaluation of Gross Profit Method
Disadvantages:
1. It is an estimate.
2. It generally relies on past percentages in determining
the markup.
3. Care must be exercised when applying a blanket gross
profit rate when there are varying gross profits.
Normally unacceptable for financial reporting purposes.
LO 8 262

Determine Ending Inventory by
Applying the Retail Inventory Method
LO 9 263

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