2. 12 - 1 © 2005 Accounting 1/e, Terrell/Terrell External Reporting Issues Chapter 12

3. 12 - 2 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Characterize the importance of external financial information to financial statement users.

4. 12 - 3 © 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,

5. 12 - 4 © 2005 Accounting 1/e, Terrell/Terrell External Financial Reporting The SEC requires publicly held companies to file quarterly (10Q) and annual (10K) financial statements.

6. 12 - 5 © 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.

7. 12 - 6 © 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

8. 12 - 7 © 2005 Accounting 1/e, Terrell/Terrell Comparison of Annual Earnings

9. 12 - 8 © 2005 Accounting 1/e, Terrell/Terrell Comparison of Annual Stock Prices

10. 12 - 9 © 2005 Accounting 1/e, Terrell/Terrell Importance of External Information to Creditors Long-term creditors Short-term creditors Tradecreditors Commerciallendinginstitutions

11. 12 - 10 © 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

12. 12 - 11 © 2005 Accounting 1/e, Terrell/Terrell Ethical Considerations of External Financial Reporting Ethics Goodethics is good business.

13. 12 - 12 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 2 Differentiate the different valuations used for external financial reporting.

14. 12 - 13 © 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

15. 12 - 14 © 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.

16. 12 - 15 © 2005 Accounting 1/e, Terrell/Terrell Accounting Concepts Accounting Concepts 2. Full Disclosure 3. Financial statements must be representationally faithful. 1. Consistency

17. 12 - 16 © 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.

18. 12 - 17 © 2005 Accounting 1/e, Terrell/Terrell Depreciation Time Time

19. 12 - 18 © 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates Length of the asset’s useful live Amount of residualvalue

20. 12 - 19 © 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.

21. 12 - 20 © 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

22. 12 - 21 © 2005 Accounting 1/e, Terrell/Terrell The Effect of Estimates Gains or losses are computed on the sale of assets. $Gain $Loss

23. 12 - 22 © 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.

24. 12 - 23 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Calculate depreciation using the straight-line and double- declining-balance methods.

25. 12 - 24 © 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$ 63,180 2002200520032004 Elevation Sports, Inc. Pro Forma Income Statement For the Years Ended May 31

26. 12 - 25 © 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 100,000 100,100 100,000 100,000 Retained earnings 63,180 126,360 189,540 252,720 Total liabilities and stockholders’ equity$291,980$355,160$418,340$481,520 stockholders’ equity$291,980$355,160$418,340$481,520 2002200520032004 Elevation Sports, Inc. Pro Forma Balance Sheet May 31

27. 12 - 26 © 2005 Accounting 1/e, Terrell/Terrell Double-Declining-Balance Depreciation 2002$75,000$30,000$45,000 2003 45,000 18,000 27,000 2004 27,000 10,800 16,200 2005 16,200 1,200 15,000 2006 15,000 -0- 15,000 YearBeginningbookvalueDepreciationexpenseEndingbookvalue

28. 12 - 27 © 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.

29. 12 - 28 © 2005 Accounting 1/e, Terrell/Terrell Differences in Inventory Methods Last-in, first out (LIFO) Average cost Specific identification First-in, first out (FIFO)

30. 12 - 29 © 2005 Accounting 1/e, Terrell/Terrell The Flow of Inventory Cost: Harwood Example 9-1Beginning inventory1$ 800 9-3Purchase2$1,025 9-17 Sale1 $1,500 9-22Purchase1$1,100 9-26 Purchase1$1,200 9-29 Purchase1$1,450 9-30 Sale2 $1,500 DateTransactionUnitsUnitcostUnitsellingprice

31. 12 - 30 © 2005 Accounting 1/e, Terrell/Terrell First-in, First-out Method (FIFO) Beginning inventory1 @ $ 800$ 800 9-3 Purchases2 @ $1,025 2,050 Cost of units sold$2,850 Total purchases = $5,800 What is the cost of the units sold?

32. 12 - 31 © 2005 Accounting 1/e, Terrell/Terrell First-in, First-out Method (FIFO) 9-29purchase1 @ $1,450$1,450 9-26purchase1 @ $1,200 1,200 9-22purchase1 @ $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

33. 12 - 32 © 2005 Accounting 1/e, Terrell/Terrell Last-in, First-out Method (LIFO) What is the cost of the units sold? 9-29purchase1 @ $1,450$1,450 9-26purchase1 @ $1,200 1,200 9-22purchase1 @ $1,100 1,100 Cost of units sold$3,750

34. 12 - 33 © 2005 Accounting 1/e, Terrell/Terrell Last-in, First-out Method (LIFO) What is the cost of ending inventory? Beginning inventory1 @ $ 800$ 800 9-3 purchase2 @ $1,025 2,050 Cost of ending inventory$2,850

35. 12 - 34 © 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

36. 12 - 35 © 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 200 200 200 Net income$1,450$ 550$1,000 Average costFIFOLIFOSeptember 30

37. 12 - 36 © 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 1,750 850 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

38. 12 - 37 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 Evaluate disclosure requirements for external reporting.

39. 12 - 38 © 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

40. 12 - 39 © 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, 1999 1. 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

41. 12 - 40 © 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) 2001 2000 Target$3,348$3,090 Mervyn’s 523 561 Marshall Field’s 348 396 Other 230 201 Total Inventory$4,449$4,248

42. 12 - 41 © 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)

43. 12 - 42 © 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)

44. 12 - 43 © 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 3.40 6.12 6.03 Days inventory 107.4 59.6 60.5 (365 ÷ Inventory turnover) Family Dollar Target (LIFO) Target (FIFO)(in millions)

45. 12 - 44 © 2005 Accounting 1/e, Terrell/Terrell End of Chapter 12