© 2005 Accounting 1/e, Terrell/Terrell External Reporting Issues Chapter 12

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Characterize the importance of external financial information to financial statement users.

© 2005 Accounting 1/e, Terrell/Terrell External Financial Reporting in assessing future cash flows, and identifying enterprise resources, claims to resources, and changes in them. The objective of accounting is to provide information that is useful in making investment and credit decisions,

© 2005 Accounting 1/e, Terrell/Terrell External Financial Reporting The SEC requires publicly held companies to file quarterly (10Q) and annual (10K) financial statements.

© 2005 Accounting 1/e, Terrell/Terrell Importance of External Information to Shareholders Shareholders and potential investors expect safety for their investment and return on the investment. and return on the investment.

© 2005 Accounting 1/e, Terrell/Terrell The Road to Bankruptcy Beware of illiquidity Now entering unprofitableregions Danger ahead! Watch out for insolvency Bankruptcy Net profit Financialhealth

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Annual Earnings

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Annual Stock Prices

© 2005 Accounting 1/e, Terrell/Terrell Importance of External Information to Creditors Long-term creditors Short-term creditors Tradecreditors Commerciallendinginstitutions

© 2005 Accounting 1/e, Terrell/Terrell Importance of External Information to Regulators Regulators depend upon periodic reports from the organizations they oversee as evidence of compliance with rules and regulations. – Internal Revenue Service – Securities and Exchange Commission – State taxation agencies – Utility rate-setting agencies

© 2005 Accounting 1/e, Terrell/Terrell Ethical Considerations of External Financial Reporting Ethics Goodethics is good business.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 2 Differentiate the different valuations used for external financial reporting.

© 2005 Accounting 1/e, Terrell/Terrell External Reporting Valuation Net realizable value Lower of cost or market Fair value or market value Historical cost Present value

© 2005 Accounting 1/e, Terrell/Terrell Alternative Accounting Principles Alternative accounting principles have developed because of such differences. Using one accounting method instead of another should not make a material difference in economic decision making. Many businesses have different reporting requirements due to the nature of their industry.

© 2005 Accounting 1/e, Terrell/Terrell Accounting Concepts Accounting Concepts 2. Full Disclosure 3. Financial statements must be representationally faithful. 1. Consistency

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 3 Compare and contrast the straight-line and double- declining-balance methods of depreciation and the effects of using each on the balance sheet and income statement.

© 2005 Accounting 1/e, Terrell/Terrell Depreciation Time Time

© 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates Length of the asset’s useful live Amount of residualvalue

© 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates It is assumed that the equipment would last for five years. Its estimated residual value is $15,000. What is the depreciation expense? Elevation Sports, Inc., purchased equipment for $75,000.

© 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates $60,000 ÷ 5 = $12,000 What is the depreciation expense if its estimated residual value is $13,000. $75,000 – $15,000 = $60,000 $75,000 – $13,000 = $62,000 $62,000 ÷ 5 = $13,000

© 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates Gains or losses are computed on the sale of assets. $Gain $Loss

© 2005 Accounting 1/e, Terrell/Terrell Straight-Line and Accelerated Depreciation Methods Accelerated depreciation methods record a large amount of depreciation expense in the early years of an asset’s life. The straight-line method assumes an asset is used equally in each time period of its useful life.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Calculate depreciation using the straight-line and double- declining-balance methods.

© 2005 Accounting 1/e, Terrell/Terrell Straight-Line Depreciation Income before depreciation$117,300$117,300$117,300$117,300 Depreciation 12,000$ 12,000$ 12,000$ 12,000 Income before taxes$105,300$105,300$105,300$105,300 Income tax expense 42,120 42,120 42,120 42,120 Net income$ 63,180$ 63,180$ 63,180$ 63, Elevation Sports, Inc. Pro Forma Income Statement For the Years Ended May 31

© 2005 Accounting 1/e, Terrell/Terrell Straight-Line Depreciation Cash$132,880$208,060$283,240$358,420 Other current assets 61,800 61,800 61,800 61,800 Equipment 75,000 75,000 75,000 75,000 Less: Acc. depreciation (12,000) (12,000) (12,000) (12,000) Other assets 34,300 34,300 34,300 34,300 Total assets$291,980$355,160$418,340$481,520 Total liabilities$128,800$128,800$128,800$128,800 Common stock 100, , , ,000 Retained earnings 63, , , ,720 Total liabilities and stockholders’ equity$291,980$355,160$418,340$481,520 stockholders’ equity$291,980$355,160$418,340$481, Elevation Sports, Inc. Pro Forma Balance Sheet May 31

© 2005 Accounting 1/e, Terrell/Terrell Double-Declining-Balance Depreciation 2002$75,000$30,000$45, ,000 18,000 27, ,000 10,800 16, ,200 1,200 15, , ,000 YearBeginningbookvalueDepreciationexpenseEndingbookvalue

© 2005 Accounting 1/e, Terrell/Terrell Learning Objectives 5 and 6 Compare and contrast different methods of accounting for inventories and the effects of using each on the balance sheet and income statement. Compute inventories using different methods.

© 2005 Accounting 1/e, Terrell/Terrell Differences in Inventory Methods Last-in, first out (LIFO) Average cost Specific identification First-in, first out (FIFO)

© 2005 Accounting 1/e, Terrell/Terrell The Flow of Inventory Cost: Harwood Example 9-1Beginning inventory1$ Purchase2$1, Sale1 $1, Purchase1$1, Purchase1$1, Purchase1$1, Sale2 $1,500 DateTransactionUnitsUnitcostUnitsellingprice

© 2005 Accounting 1/e, Terrell/Terrell First-in, First-out Method (FIFO) Beginning $ 800$ $1,025 2,050 Cost of units sold$2,850 Total purchases = $5,800 What is the cost of the units sold?

© 2005 Accounting 1/e, Terrell/Terrell First-in, First-out Method (FIFO) $1,450$1,450 $1,200 1,200 $1,100 1,100 Cost of ending inventory$3,750 Beginning inventory $800 + Purchases $5,800 = Goods available for sale $6,600 $6,600 – $3,750 = Cost of goods sold $2,850

© 2005 Accounting 1/e, Terrell/Terrell Last-in, First-out Method (LIFO) What is the cost of the units sold? $1,450$1,450 $1,200 1,200 $1,100 1,100 Cost of units sold$3,750

© 2005 Accounting 1/e, Terrell/Terrell Last-in, First-out Method (LIFO) What is the cost of ending inventory? Beginning $ 800$ $1,025 2,050 Cost of ending inventory$2,850

© 2005 Accounting 1/e, Terrell/Terrell Average Cost Method Cost of goods available for sale $6,600–Endinginventory$3,300 (3 × $1,100) = Cost of goods sold $3,300 (3 × $1,100) Average cost = $6,600 ÷ 6 = $1,100/unit

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Methods: Income Statement Sales$4,500$4,500$4,500 Cost of goods sold 2,850 3,750 3,300 Gross margin$1,650$ 750$1,200 Operating expenses Net income$1,450$ 550$1,000 Average costFIFOLIFOSeptember 30

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Methods: Balance Sheet Cash$21,000$22,300$22,300$22,300 Accounts receivable 1,500 4,500 4,500 4,500 Merchandise inventory 800 3,750 2,850 3,300 Total assets$23,300$30,550$29,650$30,100 Accounts payable$ -0-$ 5,800$ 5,800$ 5,800 Common stock 15,000 15,000 15,000 15,000 Additional paid-in capital 8,000 8,000 8,000 8,000 Retained earnings 300 1, ,300 Total liabilities and stockholders’ equity$23,300$30,550$29,650$30,100 stockholders’ equity$23,300$30,550$29,650$30,100 Average cost FIFOLIFO September 30August 31

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 Evaluate disclosure requirements for external reporting.

© 2005 Accounting 1/e, Terrell/Terrell Reporting Inventories in the Notes to Financial Statements Before IRS instituted the LIFO Conformity Rule, many firms used FIFO inventory for financial statements and LIFO inventory for tax purposes. The LIFO Conformity Rule changed this practice by requiring firms to use the same inventory method for tax purposes that they use for financial statements purposes

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Inventory Disclosures Family Dollar Stores, Inc. and Subsidiaries Notes to Consolidated Financial Statements Years Ended September 1, 2001, August 26, 2000, and August 28, Description of Business and Summary of Significant Accounting Policies: Merchandise inventories: Inventories are valued using retail prices less markon percentages, and approximate the lower of first-in, first-out (FIFO) cost or market

© 2005 Accounting 1/e, Terrell/Terrell Comparison of Inventory Disclosures Target Corporation and subsidiaries notes to financial statements Inventory Inventory and the related cost of sales are accounted for by the retail inventory accounting method using the last-in, first-out (LIFO) basis and are stated at the lower of LIFO cost or market. The cumulative LIFO provision was $64 million and $57 million at year-end 2001 and 2000, respectively. Inventory (millions) Target$3,348$3,090 Mervyn’s Marshall Field’s Other Total Inventory$4,449$4,248

© 2005 Accounting 1/e, Terrell/Terrell Implications of LIFO and Ratio Comparisons Sales$3,665$39,176$39,176 Cost of sales 2,439 27,246 27,239 Gross margin$1,226$11,930$11,937 Profit before taxes$ 298$ 2,216$ 2,223 Ending inventory$ 722$ 4,449$ 4,513 Family Dollar Target (LIFO) Target (FIFO)(in millions)

© 2005 Accounting 1/e, Terrell/Terrell Implications of LIFO and Ratio Comparisons Gross margin$1,226$11,930$11,937 ÷Sales$3,665$39,176$39,176 =Gross profit %33.45%30.45%30.47% Profit before taxes$ 298$ 2,216$ 2,223 ÷Sales$3,665$39,176$39,176 =Profit margin before taxes 8.13% 5.66% 5.67% Family Dollar Target (LIFO) Target (FIFO)(in millions)

© 2005 Accounting 1/e, Terrell/Terrell Implications of LIFO and Ratio Comparisons Cost of sales$2,439$27,246$27,239 ÷Inventory$ 722$ 4,449$ 4,513 =Inventory turnover Days inventory (365 ÷ Inventory turnover) Family Dollar Target (LIFO) Target (FIFO)(in millions)

© 2005 Accounting 1/e, Terrell/Terrell End of Chapter 12