Financial Accounting 6th Edition

Weygandt Solutions Manual

Visit to Download in Full: https://testbankdeal.com/download/financial-accounting-6th-
edition-weygandt-solutions-manual/
 CHAPTER 7
Accounting Principles

ASSIGNMENT CLASSIFICATION TABLE

Brief A B
Study Objectives Questions Exercises Exercises Problems Problems

1. Explain the meaning of 1, 2 1, 2

GAAP and identify the key
items of the conceptual
framework.

2. Describe the basic 3 3

objectives of financial
reporting.

3. Discuss the qualitative 3, 4, 5 4, 5, 6

characteristics of
accounting information
and elements of financial
statements.

4. Identify the basic 6 7 1, 2, 3 1A, 2A, 3A 1B, 2B, 3B

assumptions used by
accountants.

5. Identify the basic principles 7, 8, 9, 10, 7 1, 2, 3, 4 1A, 2A, 3A 1B, 2B, 3B

of accounting. 12

6. Identify the two constraints 11 7, 8 1, 2, 3 3A 3B

in accounting.

7. Understand and analyze 13, 14, 15, 9, 10, 11 5, 6, 7, 8, 4A, 5A 4B, 5B

classified financial 16 9
statements.

8. Explain the accounting 17, 18 10

principles used in
international operations.

© 2008 For Instructor Use Only 7-1

ASSIGNMENT CHARACTERISTICS TABLE

Problem Difficulty Time

Number Description Level Allotted (min.)

1A Analyze transactions to identify accounting principle or Moderate 20−30

assumption violated, and prepare correct entries.

2A Determine the appropriateness of journal entries in Moderate 20−30

terms of generally accepted accounting principles or
assumptions.

3A Identify accounting assumptions, principles, and Moderate 20−30

constraints.

4A Prepare a classified balance sheet and analyze financial Moderate 35−45

position.

5A Prepare a multiple-step income statement and analyze Moderate 35−45

profitability.

1B Analyze transactions to identify accounting principle or Moderate 20−30

assumption violated, and prepare correct entries.

2B Determine the appropriateness of journal entries in Moderate 20−30

terms of generally accepted accounting principles or
assumptions.

3B Identify accounting assumptions, principles, and Moderate 20−30

constraints.

4B Prepare a classified balance sheet and analyze Moderate 35−45

financial position.

5B Prepare a multiple-step income statement and analyze Moderate 35−45

profitability.

7-2 © 2008 For Instructor Use Only

© 2008

BLOOM’ S TAXONOMY TABLE

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

Study Objective Knowledge Comprehension Application Analysis Synthesis Evaluation

1. Explain the meaning of GAAP Q7-1 BE7-1
For Instructor Use Only

and identify the key items of Q7-2

the conceptual framework. BE7-2
2. Describe the basic objectives Q7-3
of financial reporting. BE7-3
3. Discuss the qualitative BE7-4 Q7-3
characteristics of accounting BE7-5 Q7-4
information and elements of BE7-6 Q7-5
financial statements.
4. Identify the basic assumptions BE7-7 Q7-6 P7-3A E7-2 P7-1B
used by accountants. E7-1 P7-3B P7-1A P7-2B
E7-3 P7-2A
5. Identify the basic principles of BE7-7 Q7-7 E7-1 Q7-8 E7-2 P7-2B
accounting. Q7-8 E7-3 E7-4 P7-1A
Q7-9 P7-3A P7-2A
Q7-10 P7-3B P7-1B
Q7-12
6. Identify the two constraints in Q7-11 E7-1 P7-3A BE7-8 E7-2
accounting. BE7-7 E7-3 P7-3B
7. Understand and analyze Q7-14 Q7-16 E7-6 Q7-13 P7-4B Q7-13 P7-5B
classified financial statements. Q7-15 BE7-9 E7-7 E7-8 P7-5B P7-4A
BE7-10 E7-8 P7-4A P7-5A
BE7-11 E7-9 P7-5A P7-4B
E7-5
8. Explain the accounting Q7-18 Q7-17 E7-10
principles used in international
operations.
Financial Reporting Decision Making Decision Making Ethics Case
Broadening Your Perspective Communication Communication Across the Across the Decision Making
Exploring the Web Organization Organization Across the
Comp. Analysis Organization
Comp. Analysis
7-3
 ANSWERS TO QUESTIONS

1. (a) Generally accepted accounting principles (GAAP) are a set of standards and rules, having
substantial authoritative support, that are recognized as a general guide for financial
reporting.
(b) The bodies that provide authoritative support for GAAP are the Financial Accounting Standards
Board (FASB) and the Securities and Exchange Commission (SEC).
2. The FASB’s conceptual framework consists of the following:
(1) Objectives of Financial Reporting.
(2) Qualitative Characteristics of Accounting Information.
(3) Elements of Financial Statements.
(4) Operating Guidelines (Assumptions, Principles, and Constraints).
3. (a) According to the FASB in its development of the conceptual framework, the objectives of
financial reporting are to provide information that: (1) is useful to those making investment and
credit decisions, (2) is helpful in assessing future cash flows, and (3) identifies the economic
resources (assets), the claims to those resources (liabilities), and the changes in those
resources and claims.
(b) The qualitative characteristics are: (1) relevance, (2) reliability, (3) comparability, and
(4) consistency.
4. Quiney is correct. Consistency means using the same accounting principles and accounting methods
from period to period within a company. Without consistency in the application of accounting
principles, it is difficult to determine whether a company is better off, worse off, or the same from
period to period.
5. Comparability results when different companies use the same accounting principles. Consistency
means using the same accounting principles and methods from year to year within the same
company.
6. The going concern assumption is necessary because otherwise depreciation and amortization
policies would not be justifiable and appropriate. Also, the current-noncurrent classification of
assets and liabilities would lose much of its significance. Labeling anything as fixed or long-term
would be difficult to justify. In addition, the going concern assumption lends credibility to the cost
principle.
7. Revenue should be recognized in the accounting period in which it is earned. The sales basis
involves an exchange transaction between the seller and buyer and the sales price provides an
objective measure of the amount of revenue realized.
8. Expired costs generate revenues only in the current period and therefore are expensed immediately.
Unexpired costs will generate revenues in current and future periods and are recorded as assets.
9. (a) The accountant discloses information about an entity’s financial position, operations, and cash
flows in the financial statements, or in the notes that accompany the statements.
(b) The trade-offs involved with disclosure balance the costs of preparing additional information and
the benefits from using it.

7-4 © 2008 For Instructor Use Only

Questions Chapter 7 (Continued)

10. Cost is used because it is both relevant and reliable. Cost is relevant because it represents the price
paid, the assets sacrificed, or the commitment made at the date of acquisition. Cost is reliable
because it is objectively measurable, factual, and verifiable. It is the result of an exchange transaction.
As a result, cost is the basis used in preparing financial statements.

11. The two constraints are materiality and conservatism. The materiality constraint means that an item
may be so small that failure to follow generally accepted accounting principles will not influence the
decision of a reasonably prudent investor or creditor. The conservatism constraint means that when
in doubt, the accountant chooses the accounting method that is least likely to overstate assets and
net income.

12. Recording Osterhaus’ additional investment of $5,000 as revenues is inappropriate. An investment in a

corporation increases the common stock account, not revenues.

13. Three relationships that are helpful in assessing profitability are: (1) the profit margin percentage (or
return on sales), (2) return on assets, and (3) return on common stockholders’ equity. More than one
profitability relationship is useful in that the relationships help in different types of analysis. Return on
sales, for example, measures the percentage of each sales dollar that is included in net income,
whereas return on assets measures the contribution of each dollar of assets in generating income.
The former, then, helps analyze profits in terms of revenues alone; the latter helps analyze profits in
terms of the asset base in generating sales and profits. If the return on assets is lower than
warranted, the company may not be using its assets effectively; if return on sales is lower than
warranted, the company may not be controlling costs effectively.

14. Natasha Company’s working capital (a) is $60,000 – $20,000 = $40,000, and its current ratio
(b) is $60,000 ÷ $20,000 = 3:1.

15. Whenever current assets are less than current liabilities, working capital is negative and the current
ratio will be less than 1:1. (Whenever current assets are greater than current liabilities, working
capital is positive and the current ratio is greater than 1:1.)

16. A debt to total assets ratio of 62% is fairly substantial. But more is involved in a credit decision than
just one financial statement relationship. Extension of additional credit will depend on Bozeman’s
overall liquidity (current ratio) and profitability (ability to generate revenue and cash) over the life of
the loan. Similarly, Bozeman’s credit history is important—its patterns of loan
repayment in the past. No one analytical relationship can provide sufficient information to determine
granting of additional credit.

17. There is little uniformity in accounting standards from country to country, although some efforts have
been made in this area by the International Accounting Standards Board.

18. The International Accounting Standards Board establishes international accounting standards,
although they are by no means universally applied.

© 2008 For Instructor Use Only 7-5

 SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 7-1

(a) True.
(b) False.
(c) True.

BRIEF EXERCISE 7-2

(a) No.
(b) Yes.
(c) Yes.

BRIEF EXERCISE 7-3

(a) No.
(b) Yes.
(c) Yes.

BRIEF EXERCISE 7-4

(a) Predictive value.

(b) Feedback value.
(c) Consistency.
(d) Faithful representation.
(e) Verifiable.

BRIEF EXERCISE 7-5

(a) Relevant.
(b) Reliability.
(c) Consistency.

7-6 © 2008 For Instructor Use Only

BRIEF EXERCISE 7-6

(a) 1.
(b) 2.
(c) 3.
(d) 4.

BRIEF EXERCISE 7-7

(a) 2.
(b) 3.
(c) 1.
(d) 4.

BRIEF EXERCISE 7-8

(a) Conservatism.
(b) Conservatism.
(c) Materiality.
(d) Materiality.

BRIEF EXERCISE 7-9

Current Assets Current Liabilities

Cash $ 110,600 Accounts payable $ 584,600
Accounts receivable 1,674,400 Income taxes payable 25,900
Total $1,785,000 Other current liabilities 608,500
Total $1,219,000

(a) Current ratio = Current assets ÷ Current liabilities

= $1,785,000 ÷ $1,219,000
= 1.46:1

(b) Working capital = Current assets – Current liabilities

= $1,785,000 – $1,219,000
= $566,000

© 2008 For Instructor Use Only 7-7

BRIEF EXERCISE 7-10

Gross profit $907,000

667,000 = Operating expenses (a)
Income from operations 240,000
Other revenues and gains 36,000
Income before income taxes 276,000
96,600 = Income tax expense (b)
Net income $179,400

BRIEF EXERCISE 7-11

Earnings per share = Net income ÷ common shares outstanding

= $179,400 ÷ 46,000
= $3.90

7-8 © 2008 For Instructor Use Only

 SOLUTIONS TO EXERCISES

EXERCISE 7-1

1. Revenue recognition principle.

2. Full disclosure principle.
3. Matching principle.
4. Going concern assumption.
5. No violation.
6. Time period assumption.
7. Cost principle.
8. Economic entity assumption.

EXERCISE 7-2

(a) This is a violation of the cost principle. The inventory was written up to
its market value when it should have remained at cost. Thus, no journal
entry should have been made.

(b) This is also a violation of the cost principle because the equipment was
recorded at its estimated market value and not its exchange value. The
correct journal entry is:

Equipment ................................................................. 41,000

Cash.................................................................... 41,000

(c) This is a violation of the economic entity assumption. The accounting for
the transaction treats Mark Nabke and Vicki Prowitz Company as one
entity when they are two separate entities. No journal entry should have
been made since Nabke should have used personal assets to purchase
the truck. If cash assets of the company were used, the debit entry could
be to Accounts Receivable—M. Nabke.

(d) This is a question of matching and materiality. The pencil sharpener

could be depreciated to match the expense with revenue since the pencil
sharpener has an estimated useful life of 5 years. However, the pencil
sharpener should not be depreciated because the cost of it is not
material. Since the cost of the sharpener is not material, it should

© 2008 For Instructor Use Only 7-9

EXERCISE 7-2 (Continued)

be expensed immediately. The correct journal entry at the time of

purchase is:

Miscellaneous Expense .......................................................... 50

Cash ................................................................................. 50

EXERCISE 7-3

(a) 2. Going concern assumption.

(b) 1. Economic entity assumption.
(c) 7. Full disclosure principle.
(d) 3. Monetary unit assumption.
(e) 9. Materiality.
(f) 4. Time period assumption.
(g) 6. Matching principle.
(h) 5. Cost principle.

EXERCISE 7-4

1. $9,000. The full amount of the policy should be recognized as revenue

because the term expired within the current year.

2. $30,000 ÷ 12 = $2,500; $2,500 X 4 = $10,000. By applying the revenue

recognition principle, one can determine that 4 months of the lease
receipts should be recognized as revenue in 2008, while the remainder is
revenue in 2009.

3. $14,000. Ownership of the merchandise transfers at December 31

because the terms are FOB shipping point. Thus, a sale has occurred and
revenue should be recognized.

4. $0. No revenue should be recognized until the sale of the inventory has
occurred.

7-10 © 2008 For Instructor Use Only

EXERCISE 7-5

Net sales ............................................................. $696,000

Cost of goods sold ............................................ 409,200
Gross profit ........................................................ 286,800
Operating expenses
Selling expenses ........................................ $ 98,600
Administrative expenses ........................... 116,000 214,600
Income from operations .................................... 72,200
Other revenues and gains ................................. 17,500
Other expenses and losses............................... (34,700) (17,200)
Income before income taxes ............................. 55,000
Income tax expense (at 30%) ............................ 16,500
Net income ......................................................... $ 38,500

Earnings per share (10,000 shares) .................. $3.85

EXERCISE 7-6

(a) WILKINSON CORPORATION

Income Statement
For the Year Ended December 31, 2008

Revenues
Net sales .............................................. $2,156,900
Gain on the sale of equipment ........... 80,000
Interest revenue .................................. 300,000
Total revenues ............................. 2,536,900
Expenses
Cost of goods sold ............................. $1,499,900
Selling and administrative
expenses ......................................... 340,750
Interest expense ................................. 90,000
Total expenses ............................ 1,930,650
Income before income taxes ..................... 606,250
Income tax expense ................................... 150,000
Net income .................................................. $ 456,250

Earnings per share ..................................... $12.85

© 2008 For Instructor Use Only 7-11

EXERCISE 7-6 (Continued)

(b) (1) Gross profit = Net sales – Cost of goods sold

$2,156,900 – $1,499,900 = $657,000.

(2) Income from operations = Gross profit – Selling and admin. exp.
$657,000 – $340,750 = $316,250.

(3) Net income is the same, regardless of format: $456,250.

(c) Profit margin percentage (rate of return on sales) = Net income ÷ Net sales
= $456,250 ÷ $2,156,900
= 21.15%

EXERCISE 7-7

(a) Intel Johnson Motorola,

Relationship Corp. & Johnson Inc.
Debt to total assets 19.7% 44.3% 60.5%
Profit margin percentage 18.7% 17.2% 3.3%
Return on assets 12.0% 14.9% 2.8%
Return on common
stockholders’ equity 14.9% 26.8% 7.0%

(b) All three companies are manufacturers and distributors of products, each
being a leader in its product industry—Intel as a manufacturer of high-
tech computer chips and processors; Johnson & Johnson as a
manufacturer of health care products; and Motorola as a manufacturer of
electronics and communication products. Intel and Johnson & Johnson are
the dominant players in their industries and enjoy competitive advantages
and operating efficiencies that earn above average returns
on sales, assets, and stockholders’ equity; both had very profitable
performances. Motorola in this year was still recovering (staging a
turnaround) from several years of operating losses and a change in
management as well as a bursting of the high-tech industry bubble—
therefore its low return on sales, assets, and stockholders’ equity.

7-12 © 2008 For Instructor Use Only

EXERCISE 7-8
(a) Southern Toys “R” Intel
Relationship Company Us, Inc. Corp.
Debt to total assets 72.5% 58.7% 19.7%
Return on sales 13.1% 2.0% 18.7%
Return on assets 4.2% 2.2% 12.0%
Return on common stockholders’
equity 15.3% 5.4% 14.9%
(b) Much of the differences in the three companys’ ratios are due to the
industry differences—Southern Company is a large electric utility with
steady, consistent but moderate sales and income from a heavy
investment in plant and equipment. Southern Company can shoulder a
large amount of debt (72.5% of total assets) because of its large amount
of assets, semi monopolistic business, and its steady income and cash
flow.
While Toys “R” Us Inc. is a leading toy retailer, it is in a highly competitive
industry with low returns and low margins.
Intel is in the high-tech industry which can be cyclical, therefore more
modestly, debt encumbered, but, because of Intel’s research and develop-
ment, plants for micro chips and processors, and efficient operations, it
is highly competitive and profitable; thus, its high return on sales, assets,
and stockholders’ equity.

EXERCISE 7-9

Working capital = Current assets – Current liabilities

= $800,000
Current assets = $800,000 + Current liabilities
Current assets
Current ratio = = 2.6:1
Current liabilities
$800,000 + Current liabilities
2.6 =
Current liabilities

2.6 X Current liabilities = $800,000 + Current liabilities

2.6 X Current liabilities – Current liabilities = $800,000
1.6 X Current liabilities = $800,000
Current liabilities = $800,000 ÷ 1.6
= $500,000

© 2008 For Instructor Use Only 7-13

EXERCISE 7-9 (Continued)

Current assets = $800,000 + Current liabilities

= $800,000 + $500,000
= $1,300,000

Long-term assets = 0.5 Total assets

= Current assets

Total assets = 2 X Current assets

= 2 X $1,300,000
= $2,600,000

Total liabilities = 60% X Total assets

= 0.6 X $2,600,000
= $1,560,000

Long-term liabilities = Total liabilities – Current liabilities

= $1,560,000 – $500,000
= $1,060,000

Stockholders’ equity = Total assets – Total liabilities

= $2,600,000 – $1,560,000
= $1,040,000

ARUBA CORPORATION
Balance Sheet
December 31, 2008

Assets Liabilities and

Current assets $1,300,000 Stockholders’ Equity
Long-term assets 1,300,000 Current liabilities $ 500,000
Total assets $2,600,000 Long-term liabilities 1,060,000
Total liabilities 1,560,000
Stockholders’ equity 1,040,000
Total liabilities
& stockholders’
equity $2,600,000

7-14 © 2008 For Instructor Use Only

EXERCISE 7-10

(a) BATTEN LTD.

Partial Balance Sheet (in U.S. format)
(in thousands)

Assets
Current assets
Cash............................................................................. $ 62,000
Short-term investments ............................................. 53,000
Accounts receivable ................................................... 121,000
Inventories .................................................................. 300,000
Total current assets ............................................ 536,000
Property, plant, and equipment ......................................... 900,000
Total assets ................................................................. $1,436,000

(b) Stockholders’ equity = “Total net assets” = $1,096,000

© 2008 For Instructor Use Only 7-15

 SOLUTIONS TO PROBLEMS

PROBLEM 7-1A

1. Going concern assumption. Liquidation value is not appropriate because it

assumes that the company will not continue. No entry is necessary. Only
when liquidation appears imminent is the going concern assumption
inapplicable.

2. Matching principle. The purchase of equipment should not be expensed

immediately. Only costs which have no future benefit are recognized
immediately as expenses. Reporting a lower net income is not a
legitimate reason for expensing a piece of equipment. Therefore, the
following entry is necessary in 2008:

Depreciation Expense ($36,000 ÷ 6 years) .............. 6,000

Accumulated Depreciation—Equipment ......... 6,000

3. Matching principle. Plant assets should be expensed in a rational and

systematic manner. Deferring depreciation is not rational and systematic.
Therefore, the following entry is necessary in 2008:

Depreciation Expense .............................................. 18,000

Accumulated Depreciation ............................... 18,000

4. Cost principle. Appreciation in value does not justify a gain until the land
is sold. Appreciation does not involve an exchange transaction. No entry
is necessary.

5. Cost principle. Recording the transaction at its estimated market value

would not be proper because estimated market value in this case does
not represent an exchange price. The purchase should be recorded at
cost, not at a market price that someone believes the equipment is
worth. The correct entry is:

Equipment ................................................................. 35,000

Cash ................................................................... 35,000

7-16 © 2008 For Instructor Use Only

 PROBLEM 7-2A

1. The proper amount of depreciation expense is based on the cost of

the asset and is not adjusted for changing price levels. Depreciation is
not so much a matter of valuation as it is a means of cost allocation.
Assets are not depreciated on the basis of a decline in their fair market
value, but are depreciated on the basis of systematic charges of
expired costs against revenues. (Note: It might be called to the students’
attention that the FASB does encourage supplemental disclosure of
price-level information.)

2. The cost principle indicates that assets and liabilities are to be

accounted for on the basis of cost. If we were to select sales value, for
example, we would have an extremely difficult time in attempting to
establish a sales value for the given item without selling it. It should
further be noted that the revenue recognition principle provides the
answer to when revenue (gain) should be recognized. Revenue should be
recognized when it is earned. In this situation, an earnings process has
definitely not taken place.

3. This entry violates the economic entity assumption. This assumption

in accounting indicates that economic activity can be identified with a
particular unit of accountability. In this situation, the company erred by
charging this cost to the wrong economic entity.

4. It appears from the information that the sale should be recorded in the
next year instead of the current year. Regardless of whether the terms are
FOB shipping point or FOB destination, the point is that the inventory is
to be sold in the next year. Therefore, the revenue recognition principle is
violated. It should be noted that if the company is employing a perpetual
inventory system in dollars and quantities, a debit to Cost of Goods Sold
and a credit to Inventory are also necessary in the next year.

5. A gain should not be recognized until the inventory is sold. Account-ants

follow the cost approach and write-ups of assets are not permitted. It
should also be noted that the revenue recognition principle indicates that
revenue (gain) should not be recognized until it is earned.

© 2008 For Instructor Use Only 7-17

 PROBLEM 7-3A

(a) 2. Going concern assumption.

(b) 3. Monetary unit assumption.

(c) 9. Materiality.

(d) 7. Matching principle.

(e) 1. Economic entity assumption.

(f) 4. Time period assumption.

(g) 6. Revenue recognition principle.

(h) 10. Conservatism.

(i) 5. Full disclosure principle.

7-18 © 2008 For Instructor Use Only

 PROBLEM 7-4A

(a) QUAD CITIES TOURS INC.

Balance Sheet
October 31, 2008
Assets
Current assets
Cash $ 36,000
Investment in Iowa Trading Post, Inc. 140,000
Accounts receivable 15,000
Inventories 485,000
Supplies 12,000
Prepaid expenses ($17,000 + $9,000) 26,000
Total current assets 714,000

Property, plant, and equipment

Land $653,000
Buildings $660,000
Less: Accum. deprec. 144,000 516,000

Equipment 840,000
Less: Accum. deprec. 715,000 125,000 1,294,000
Total assets $2,008,000

Liabilities and Stockholders’ Equity

Current liabilities
Notes payable $ 164,000
Accounts payable 170,000
Income taxes payable 56,250
Interest payable 30,000
Total current liabilities 420,250

Bonds payable 600,000

Mortgage payable 247,750 847,750
Total liabilities 1,268,000

Stockholders’ equity
Common stock 300,000
Retained earnings 440,000 740,000
Total liabilities and stockholders’ equity $2,008,000

© 2008 For Instructor Use Only 7-19

PROBLEM 7-4A (Continued)

$714,000
(b) Current ratio: = 1.70:1
$420,250

$1,268,000
Debt to total assets: = 63.1%
$2,008,000

Working capital: $714,000 – $420,250 = $293,750

(c) Debt already represents a substantial portion of Quad Cities’ balance

sheet. The current ratio is fairly solid, and working capital is significantly
positive (it is enough to cover the outstanding long-term mortgage, for
example). The balance sheet does not provide any information about
Quad Cities’ profitability and long-term prospects for generating cash.
Without information that would help you determine Quad Cities’ cash-
generating ability at least over the life of the requested loan, you would be
unlikely to approve the request for added borrowings. That is, you need
more information, especially about the income-generating ability of the
company.

7-20 © 2008 For Instructor Use Only

 PROBLEM 7-5A

(a) MID CITY GALLERIES INC.

Income Statement
For the Year Ended December 31, 2008

Net sales $9,275,000

Cost of goods sold

Beginning inventory $1,650,000
Net purchases 3,200,000
Freight-in 232,000 3,432,000
Goods available for
sale 5,082,000
Ending inventory 1,424,000
Cost of goods sold 3,658,000
Gross profit 5,617,000

Operating expenses
Selling expenses
Commissions expense $1,200,000
Advertising expense 123,000
Freight-out 82,500
Miscellaneous selling
expenses 39,000 1,444,500
Administrative expenses
Wages and salaries 1,264,000
Rent expense 808,000
Insurance expense 600,000
Utilities expense 117,000
Depreciation expense 98,000
Miscellaneous
administrative
expenses 53,200 2,940,200
Total operating
expenses 4,384,700
Income from operations 1,232,300

© 2008 For Instructor Use Only 7-21

PROBLEM 7-5A (Continued)

MID CITY GALLERIES INC.

Income Statement (Continued)
For the Year Ended December 31, 2008

Other revenues and gains

Dividend revenue 50,000
Other expenses and losses
Interest expense 98,000
Loss on the sale of
office equipment 21,300 119,300 (69,300)
Income before income taxes 1,163,000

Income tax expense ($1,163,000 X .30) 348,900

Net income $ 814,100

Earnings per share ($814,100 ÷ 90,000) $9.05

$814,100
(b) Profit margin percentage: = 8.78%
$9,275,000

$814,100
Return on assets: = 10.84%
$7,509,000

Return on stockholders’ $814,100

= 20.48%
equity: $3,975,400

$3,533,600*
Debt to total assets: = 47.06%
$7,509,000

*$7,509,000 – $3,975,400

(c) Return on assets is reasonable, as is the profit margin percentage (rate of

return on sales). The Galleries do, however, have a fairly large amount of
debt. Two other balance sheet relationships would be useful, in addition
to other information, before making a decision: current ratio and working
capital. These would help tell you whether or not the company can
reasonably be expected to pay its short-term obligations on time.

7-22 © 2008 For Instructor Use Only

 PROBLEM 7-1B

1. Cost principle. Appreciation in value does not justify recognizing a gain

on the land until it is sold. Appreciation does not involve an exchange
transaction. No entry is necessary.

2. Matching principle. The purchase of equipment should not be expensed

immediately. Only costs which have no future benefit are recognized
immediately as expenses. Reporting a lower net income is not a legiti-
mate reason for expensing a piece of equipment. Therefore, the following
entry is necessary:

Depreciation Expense ($60,000 ÷ 5 years)............... 12,000

Accumulated Depreciation—Equipment .......... 12,000

3. Matching principle. Plant assets should be expensed through a

rational and systematic policy. Deferring depreciation is not rational and
systematic. Therefore, the following entry is necessary:

Depreciation Expense ............................................... 26,000

Accumulated Depreciation................................ 26,000

4. Cost principle. Recording the transaction at its estimated market value

would not be proper because estimated market value in this case does
not represent an exchange price. The purchase should be recorded at
cost, not at a market price that someone believes the equipment is worth.
The correct entry is:

Equipment ................................................................. 18,000

Cash.................................................................... 18,000

5. Going concern assumption. Liquidation value is not appropriate

because it assumes that the company will not continue. No entry is
necessary. Only when liquidation appears imminent is the going concern
assumption inapplicable.

© 2008 For Instructor Use Only 7-23

PROBLEM 7-1B (Continued)

6. Matching principle. The matching principle is violated because

expensing the cost of the rent does not allow a proper matching of
expense with the period in which the revenue will occur. Revenue
associated with the rent would benefit both years. The correct entry is:

Prepaid Rent.............................................................. 24,000

Cash ................................................................... 24,000

An adjusting entry is made at December 31 to record the proper rent

expense.

Rent Expense ($24,000 X 3/12) ................................. 6,000

Prepaid Rent ...................................................... 6,000

7-24 © 2008 For Instructor Use Only

 PROBLEM 7-2B

1. The proper amount of depreciation expense is based on the cost of

the asset and is not adjusted for changing price levels. Depreciation is
not so much a matter of valuation as it is a means of cost allocation.
Assets are not depreciated on the basis of a decline in their fair market
value, but are depreciated on the basis of systematic charges of expired
costs against revenues. (Note: It might be called to the students’
attention that the FASB does encourage supplemental disclosure of
price-level information.)

2. The cost principle indicates that assets and liabilities are to be accounted
for on the basis of cost. If we were to select sales value, for
example, we would have an extremely difficult time in attempting to
establish a sales value for the given item without selling it. It should
further be noted that the revenue recognition principle provides the
answer to when revenue (gain) should be recognized. Revenue should be
recognized when it is earned. In this situation, an earnings process has
definitely not taken place.

3. It appears from the information that the sale should be recorded in the
next year instead of the current year. Regardless of whether the terms are
FOB shipping point or FOB destination, the point is that the inventory is
to be sold in the next year. Therefore, the revenue recognition principle is
violated. It should be noted that if the company is employing a perpetual
inventory system in dollars and quantities, a debit to Cost of Goods Sold
and a credit to Inventory are also necessary in the next year.

4. A gain should not be recognized until the land is sold. Accountants

follow the cost approach and write-ups of assets are not permitted. It
should also be noted that the revenue recognition principle indicates that
revenue (gain) should not be recognized until it is earned.

5. This entry violates the economic entity assumption. This assumption

in accounting indicates that economic activity can be identified with a
particular unit of accountability. In this situation, the company erred by
charging this cost to the wrong economic entity.

© 2008 For Instructor Use Only 7-25

 PROBLEM 7-3B

(a) 9. Materiality.

(b) 7. Matching principle.

(c) 3. Monetary unit assumption.

(d) 4. Time period assumption.

(e) 8. Cost principle.

(f) 1. Economic entity assumption.

(g) 5. Full disclosure principle.

(h) 10. Conservatism.

7-26 © 2008 For Instructor Use Only

 PROBLEM 7-4B

(a) GABELLI EQUIPMENT, INC.

Balance Sheet
June 30, 2008
Assets
Current assets
Cash $ 87,000
Accounts receivable 420,000
Interest receivable 21,000
Inventories 845,000
Supplies 32,000
Prepaid expenses ($9,500 + $21,000) 30,500
Total current assets 1,435,500
Investment in Spartan, Inc. bonds 600,000
Property, plant, and equipment
Land $ 212,000
Buildings $ 680,000
Less: Accum. depr. 180,000 500,000
Equipment 1,650,000
Less: Accum. depr. 577,500 1,072,500 1,784,500
Total assets $3,820,000

Liabilities and Stockholders’ Equity

Current liabilities
Notes payable $ 210,000
Accounts payable 486,000
Interest payable 70,000
Income taxes payable 47,000
Total current liabilities 813,000

Long-term liabilities
Bonds payable 1,750,000
Mortgage payable 310,000 2,060,000
Total liabilities 2,873,000

Stockholders’ equity
Common stock 500,000
Retained earnings 447,000 947,000
Total liabilities and stockholders’ equity $3,820,000

© 2008 For Instructor Use Only 7-27

PROBLEM 7-4B (Continued)

$1,435,500
(b) Current ratio: = 1.77:1
$813,000

$2,873,000
Debt to total assets: = 75.21%
$3,820,000

Working capital: $1,435,500 – $813,000 = $622,500

(c) Debt already represents a substantial portion of Gabelli’s balance sheet.

The current ratio is fairly solid but the balance sheet contains no
information about Gabelli’s overall profitability. Without a solid profit
margin and indications that Gabelli’s cash-generating ability is likely to
continue at least over the life of the requested loan, you would be
unlikely to approve the loan. That is, you need more information,
especially about the income-generating ability of the company.

7-28 © 2008 For Instructor Use Only

 PROBLEM 7-5B

(a) CAMPO LEATHERS INC.

Income Statement
For the Year Ended January 31, 2008

Net sales $2,660,000

Cost of goods sold

Beginning inventory $ 296,400
Net purchases $1,697,000
Freight-in 27,900 1,724,900
Goods available for
sale 2,021,300
Ending inventory 303,400
Cost of goods sold 1,717,900
Gross profit 942,100

Operating expenses
Selling expenses
Sales staff wages $155,000
Advertising expense 130,000
Miscellaneous selling
expenses 39,000
Freight-out 6,800 330,800
Administrative expenses
Managerial salaries 129,800
Rent expense 81,000
Insurance expense 57,000
Depreciation expense 53,000
Utilities expense 30,300
Miscellaneous
administrative
expenses 22,200 373,300
Total operating
expenses 704,100
Income from operations 238,000

© 2008 For Instructor Use Only 7-29

PROBLEM 7-5B (Continued)

CAMPO LEATHERS INC.

Income Statement (Continued)
For the Year Ended January 31, 2008

Other revenues and gains

Gain on the sale of
equipment 8,500
Interest revenue 7,000 15,500
Other expenses and losses
Interest expense 13,600 1,900
Income before income taxes 239,900

Income tax expense ($239,900 X .30) 71,970

Net income $167,930

Earnings per share ($167,930 ÷ 84,000) $2.00

$167,930
(b) Profit margin percentage: = 6.31%
$2,660,000

$167,930
Return on assets: = 3.08%
$5,460,000

Return on stockholders’ $167,930

= 8.54%
equity: $1,966,200

$3,493,800*
Debt to total assets: = 63.99%
$5,460,000

*$5,460,000 – $1,966,200

(c) Return on assets is very low, and the profit margin percentage (rate of
return on sales) is also quite low for a specialty retailer. The leather
shops are also carrying a fairly large amount of debt. Two other balance
sheet relationships would be useful, in addition to other information,
before making a decision: current ratio and working capital. These would
help tell you whether or not the company can reasonably be expected to
pay its short-term obligations on time.

7-30 © 2008 For Instructor Use Only

 COMPREHENSIVE PROBLEM: CHAPTERS 2 TO 7

(a) NU WOOD CORPORATION

Income Statement
For the Year Ended December 31, 2008
Net sales $3,590,000
Cost of goods sold 2,285,000
Gross profit 1,305,000
Operating expenses
Selling expenses $361,000
Administrative expenses 420,000 781,000
Income from operations 524,000
Other revenues and gains
Interest revenue 99,000
Gain on the sale of land 87,000 186,000
Other expenses and losses
Interest expense 108,000 78,000
Income before income taxes 602,000
Income tax expense ($602,000 X .35) 210,700
Net income $ 391,300
Earnings per share ($391,300 ÷ 80,000) $4.89

(b) NU WOOD CORPORATION

Income Statement
For the Year Ended December 31, 2008
Revenues
Net sales $3,590,000
Interest revenue 99,000
Gain on the sale of land 87,000
Total revenues 3,776,000
Expenses
Cost of goods sold $2,285,000
Administrative expenses 420,000
Selling expenses 361,000
Interest expense 108,000 3,174,000
Income before income taxes 602,000
Income tax expense 210,700
Net income $ 391,300
Earnings per share $4.89

© 2008 For Instructor Use Only 7-31

COMPREHENSIVE PROBLEM (Continued)

(c) NU WOOD CORPORATION

Retained Earnings Statement
For the Year Ended December 31, 2008

Retained Earnings, January 1 $ 877,200

Add: Net income 391,300
1,268,500
Less: Dividends 250,000
Retained Earnings, December 31 $1,018,500

(d) NU WOOD CORPORATION

Balance Sheet
December 31, 2008

Assets
Current assets
Cash $ 165,000
Marketable securities (short-term) 1,175,000
Accounts receivable 1,000,800
Inventories 984,000
Prepaid expenses 356,100
Total current assets 3,680,900
Property, plant, and equipment
Equipment $5,894,000
Less: Accumulated depreciation 1,560,000 4,334,000
Intangible assets
Patents and other intangibles 1,150,100
Total assets $9,165,000

Liabilities and Stockholders’ Equity

Current liabilities
Notes payable $1,136,500
Accounts payable 874,200
Taxes payable 234,500
Total current liabilities 2,245,200
Long-term liabilities
Bonds payable $3,300,000
Other long-term debt 401,300 3,701,300
Total liabilities 5,946,500

7-32 © 2008 For Instructor Use Only

COMPREHENSIVE PROBLEM (Continued)

NU WOOD CORPORATION
Balance Sheet (Continued)
December 31, 2008

Stockholders’ equity
Common stock 2,200,000
Retained earnings 1,018,500 3,218,500
Total liabilities and stockholders’ equity $9,165,000

Current assets $3,680,900

(e) (1) Current ratio = = = 1.64:1
Current liabilities $2,245,200

(2) Working capital = Current assets – Current liabilities

Current assets $3,680,900

Current liabilities 2,245,200
Working capital $1,435,700

Debt $5,946,500
(3) Debt to total assets = = = 64.88%
Assets $9,165,000

Although the amount of debt is relatively high in comparison with

total assets, the company is reasonably liquid; its current ratio is
better than 1.5:1, though not up to the standard 2:1. Without knowing
Nu Wood’s industry, we cannot know how typical—and reasonable—
these figures are.

Net income $391,300

(f) = = 10.90%
Net sales $3,590,000

Net income $391,300

= = 4.27%
Total assets $9,165,000

Net income $391,300

= = 12.16%
Common stockholders’ equity $3,218,500

© 2008 For Instructor Use Only 7-33

COMPREHENSIVE PROBLEM (Continued)

Nu Wood’s profit margin percentage (return on sales) is solid, but its

return on assets seems somewhat low; that is, its asset base should
produce a higher net income. Again, however, without knowing the
company’s industry, we cannot know how typical—and reasonable—
these figures are.

(g) Nu Wood Corporation’s balance sheet is stronger than that of Notting Hill
Corporation, but its profitability (except for profit margin percentage) is
weaker. The stronger profit margin percentage augurs well for Nu Wood,
particularly combined with its stronger balance sheet. We would need to
know, however, what the pattern over time has been. There may, for
example, be special circumstances that have affected the analytical
relationships for the current year. Nu Wood had a gain on the sale of
land, while Notting Hill took a small loss on the sale of equipment.
Recalculating the profit margin percentage, excluding these items (but
without adjusting income taxes), changes the profit margin percentage as
follows:

Nu Wood Corporation: $304,300

= 8.48%
(subtracting $87,000 from net income) $3,590,000

Notting Hill Corporation: $277,000

= 11.54%
(adding back $35,000 to net income) $2,400,000

With this simple adjustment, the profit margin percentage swings in

favor of Notting Hill. Therefore, even though ratios help in comparing
companies, they need to be used carefully—especially without industry
information and multiple periods of comparison.

7-34 © 2008 For Instructor Use Only

 BYP 7-1 FINANCIAL REPORTING PROBLEM

(a) A conceptual framework is similar to a constitution in that it is a

coherent system of interrelated objectives and fundamentals that can
serve as the basis for resolving accounting and reporting problems.

(b) Prior to a well-developed framework, accounting principles were

developed on a problem-by-problem basis. Thus, rule-making bodies
developed accounting rules and methods to solve specific problems.
Critics charged that the problem-by-problem approach led to inconsistent
rules and practices over time.

(c) The objectives of financial reporting are to provide information that:

(1) is useful to those making investment and credit decisions; (2) is
helpful in assessing future cash flows; and (3) identifies the economic
resources (assets), the claims to those resources (liabilities), and the
changes in those resources and claims.

(d) Generally accepted accounting principles are principles that have

“substantial authoritative support.” Substantial authoritative support
usually comes from two standard-setting bodies: The Financial Accounting
Standards Board and the Securities and Exchange Commission.

Accounting principles must be developed. It follows that the development

of a body of accounting principles is an on-going process
because accounting principles must change to reflect changes in the
business environment and changes in the needs of users of accounting
information.

(e) The qualitative characteristics of accounting discussed in the chapter are

relevance, reliability, comparability, and consistency. Relevance means
that the accounting information must be capable of making a difference
in a decision; that is, it must have a bearing on the decision. Reliability is
the quality of information that gives assurance that it is free of error and
bias; it can be depended on. Comparability results when different
companies use the same accounting principles. Consistency means
using the same accounting principles and methods from year to year
within a company.

© 2008 For Instructor Use Only 7-35

BYP 7-1 (Continued)

(f) The basic assumptions used in accounting are the economic entity
assumption, the monetary unit assumption, the time period assumption,
and the going concern assumption.

(g) The two major constraints are materiality and conservatism.

An item is material when it is likely to influence the decision of a

reasonably prudent investor or creditor. When the amount is material, the
operational guidelines of the FASB conceptual framework should be
followed.

Conservatism means that when in doubt, choose the accounting method

that will be least likely to overstate assets and income.

7-36 © 2008 For Instructor Use Only

 BYP 7-2 COMPARATIVE ANALYSIS PROBLEM

(a) PepsiCo Coca-Cola

1. Current ratio $10,454 ÷ $9,406 = 1.11:1 $10,250 ÷ $9,836 = 1.04:1

2. Working capital $10,454 – $9,406 = $1,048 $10,250 – $9,836 = $414

3. Profit margin $4,078 ÷ $32,562 = 12.5% $4,872 ÷ $23,104 = 21.1%

percentage

4. Return on assets $4,078 ÷ $31,727 = 12.9% $4,872 ÷ $29,427 = 16.6%

5. Return on com- $4,078 ÷ $14,320 = 28.5% $4,872 ÷ $16,355 = 29.8%

mon stockholders’
equity

6. Debt to total $17,476 ÷ $31,727 = 55.1% $13,072 ÷ $29,427 = 44.4%

assets

(b) Liquidity measures the ability of a company to pay its maturing obligations
and meet unexpected needs for cash. Based on the current ratio and
working capital, both PepsiCo and Coca-Cola had positive current ratios
and working capital in 2005. For every dollar of current liabilities in 2005,
PepsiCo had $1.11 of current assets while Coca-Cola had $1.04 of current
assets per dollar of current liabilities.

Profitability ratios measure the income or operating success of a com-

pany for a given period of time. Coca-Cola’s profitability ratios are all
superior to PepsiCo’s: The profit margin percentage is significantly higher
at 21.1% versus 12.5%, while Coca-Cola’s return on assets, 16.6% versus
12.9%, and its return on common stockholders’ equity, 29.8% versus
28.5%, are only slightly better.

Solvency measures the ability of an enterprise to survive over a long

period of time. The debt to total assets ratio is one measure of solvency.
The higher the percentage of debt to total assets, the greater the risk that
the company may be unable to meet its maturing obligations. PepsiCo’s
debt to total assets is 55.1% while Coca-Cola’s debt to total assets is
lower at 44.4%.

© 2008 For Instructor Use Only 7-37

 BYP 7-3 EXPLORING THE WEB

(a) The mission of the Financial Accounting Standards Board is to estab-lish

and improve standards of financial accounting and reporting for the
guidance and education of the public, including issuers, auditors, and
users of financial information.

(b) The FASB receives many requests for action on various financial
accounting and reporting topics from all segments of its diverse
constituency, including the SEC. The auditing profession is sensitive to
emerging trends in practice, and consequently it is a frequent source of
requests. Requests for action include both new topics and suggested
review or reconsideration of existing pronouncements.

(c) Actions of the FASB have an impact on many organizations within the
Board’s large and diverse constituency. It is essential that the Board’s
decision-making process be evenhanded. Accordingly, the FASB follows
and extensive “due process” that is open to public observation and
participation. This process was modeled on the Federal Administrative
Procedure Act and, in several respects, is more demanding.

7-38 © 2008 For Instructor Use Only

 BYP 7-4 DECISION MAKING ACROSS THE ORGANIZATION

(a) The underlying rationale for the current ratio is to measure the ability of a
company to pay its obligations as they become due. Included in the
numerator of the current ratio are all current assets—prepaid
assets and inventory as well as cash and receivables. If inventory and
prepaid assets represent a relatively small part of total current assets,
then the highly liquid assets like cash and receivables effectively cover
current liabilities, and a current ratio as high as 2:1 is not necessary.
Note: Most retailers have a year-end at the end of January, when their
inventories are at their lowest point. It is reasonable for current assets to
consist predominantly of liquid assets at year-end, when receivables are
high after holiday-season sales. Similar end-of-year circumstances can
apply in other industries as well. Here, only the mining /oil company’s
current ratio seems exceptionally low.
(b) The more capital-intensive the industry, the more likely the industry is to
have a high debt to total assets ratio. Oil exploration and extraction entail
large investments in equipment, so that the mining/oil company’s relatively
high ratio might be normal for the industry. A retailer that is adding
stores to its asset base would be likely to be adding mortgages on those
buildings to its total liabilities; expansion, then, is a company-specific
reason for differing debt to total assets ratios. Other explanations are
possible.
(c) Any relationship with “return” in its title has “net income” in the
numerator. A decrease in net income, all other things being equal, will
lead to a decrease in return on common stockholders’ equity. Stable net
income or even increasing net income can also occur when stockholders’
equity increases at a greater rate: new equity and new debt would
increase total assets and could lead to a decreasing return on common
stockholders’ equity and a relatively stable debt to total
assets ratio. In this particular case, the merchandising company’s net
income decreased by 26.9% and the manufacturing company’s net
income decreased by 11.8%. Neither raised substantial amounts of new
capital by either debt or equity financing.

© 2008 For Instructor Use Only 7-39

BYP 7-4 (Continued)

(d) The earnings per share measure is dependent on the number of shares
outstanding; if the number increases, EPS decreases—all other things
being equal. So the decrease in EPS, by itself, may not signal a
problem. If the decline is the result of a decrease in net income (see (c)
above), there may be greater cause for concern. Other information,
however, is likely to outweigh using just EPS alone or even a clear
decline in net income. The manufacturing company, for example, has a
history of developing new and useful products, so its long-term
prospects could easily make up for ratio deficiencies in any one year. The
merchandising company’s recent acquisitions also could provide a signal
of long-term prospects for the company.

Note to Instructors: Additional questions can easily be added to the list in

this problem, based on individual teaching emphasis for this chapter. And
additional reasons can be cited for the differential results presented here.
Students may initially experience difficulty in approaching questions such as
these without assistance. Generating discussion may be more important here
than “proper” reasons.

7-40 © 2008 For Instructor Use Only

 BYP 7-5 COMMUNICATION ACTIVITY

1. The State of California and the federal government require as a condition

of the grants to Long Beach City College that they be used within a
certain time period. The grant revenue must be matched with the
expenses during the specified grant time period. Unspent “surplus” at the
end of the grant periods must be returned. Thus, all relevant
expenses not charged to the grant must be absorbed by the college.

2. Special programs offered at your school should be identified because

they probably represent sources of revenues against which certain costs
must be matched. Programs for the handicapped (deaf, blind, etc.),
foreigners, elderly, retarded, and any group needing special education, as
well as certification programs (CPA, CMA, teacher, CFA, nursing, etc.)
and executive development and continuing professional education
programs—all of these may result from special revenue sources against
which expenses must be matched to demonstrate how the revenues were
spent and whether over-runs or surplus occurred.

3. Faculty salaries for teaching and research probably constitute the largest
share of the expenses charged to grants and special programs. Other
expenses that might be matched against the grant revenues are teaching
and research assistant salaries and wages, special equipment, laboratory
supplies, books and research materials, computer usage time, computer
software, secretarial salaries, rent of off-campus classrooms or other
space, and overhead (a significant charge made by universities to cover
administrative costs, facilities usage costs, and all incidental costs).

© 2008 For Instructor Use Only 7-41

 BYP 7-6 ETHICS CASE

(a) The stakeholders in this situation are:

• Michael Peeples, accountant.

• Financial vice-president of Bruno Corporation.
• All readers and users of Bruno Corporation’s financial statements.

(b) It is neither illegal nor professionally unethical to continue to use an

acceptable accounting method or standard when an option to change
exists. What is brought into question is whether Michael’s proposal for
early implementation of a standard that results in a much fairer presen-
tation of Bruno’s financial condition and earnings is more ethical than the
financial vice-president’s proposal to delay implementation.

(c) Michael appears to have little to gain except the satisfaction of issuing a
set of financial statements that apparently results in a much fairer
presentation of the company’s financial condition and earnings.

Early implementation, because it adversely affects reported net income,

primarily affects the stockholders.

7-42 © 2008 For Instructor Use Only

 BYP 7-7 ALL ABOUT YOU ACTIVITY

Answers will vary depending on the type of organization chosen by the

student.

© 2008 For Instructor Use Only 7-43