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More free books @ www.BingEbook.com 192 Part II: Preparing Financial Statements During the year, $18,500 has already been recorded in the bad debts expense account. As the specific receivables were identified as uncollectible during the year the business had no choice but to write-off the receivables and record bad debts expense. Using the allowance method the accountant makes the following additional entry at the end of the year, which increases the bad debts expense account: Bad Debts Expense Allowance for Doubtful Accounts $20,000 $20,000 The Allowance for Doubtful Accounts account is the contra account to the accounts receivable asset account. Its balance is deducted from the asset account’s balance in the balance sheet. After giving effect to this year-end entry, the company’s bad debts expense for the year is $38,500 ($18,500 actually written-off during the year + $20,000 estimated uncollectible receivables to be written-off in the future). In its year-end balance sheet the business reports accounts receivable at $626,500 and the $20,000 balance in the allowance for doubtful account is deducted from accounts receivable. So, the net amount of accounts receivables in its ending balance sheet is $606,500. The IRS doesn’t allow most businesses to use the allowance bad debts expense method to determine annual taxable income. (This is a terrible pun, isn’t it?) Under the income tax rules, specific accounts receivable must actually be written off in order to deduct bad debts as an expense for determining taxable income. (For more information, you can refer to IRS Publication 535, “Business Expenses” (2005), and pay particular attention to the chapter on business bad debts.) 13. The chief accountant of the business outlined in the example question is from the double-breasted, dull grey suit, old guard school of accounting. He argues that a customer’s account receivable should be written off as uncollectible when it becomes more than 30 days old. The normal credit term offered by the business to customers is 30 days. At the end of its first year, $278,400 of the company’s $645,000 accounts receivable is more than 30 days old. What bad debts expense entry would the chief accountant make at the end of the year if he had his way? Do you agree with his approach? Solve It 14. The president of the business outlined in the example question attends an industry update seminar at which the speaker says that the average bad debts experience of businesses in this field is about 1 percent of sales. Assume that the business adopts this method. Determine its bad debts expense for the first year and for the balances in its accounts receivable and allowance for doubtful accounts at the end of the year. Solve It More free books @ www.BingEbook.com Chapter 9: Choosing Accounting Methods The following two questions are comprehensive for this chapter. They draw upon the discussion throughout the chapter and the answers to the example questions in the chapter. In answering these two comprehensive questions you should also refer to the figures in the chapter. 15. Prepare the company’s income statement for its first year of business using the conservative accounting methods for cost of goods sold expense, depreciation expense, and bad debts expense. Solve It 16. Prepare the company’s income statement for its first year of business using the liberal accounting methods for cost of goods sold expense, depreciation expense, and bad debts expense. Solve It 193 More free books @ www.BingEbook.com 194 Part II: Preparing Financial Statements Answers to Problems on Choosing Accounting Methods The following are the answers to the practice questions presented earlier in this chapter. a Does the interest expense in Figure 9-1 look reasonable, or does it need an adjustment at the end of the year? Asking this kind of question at the end of the year is always a good thing for an accountant to do, to make sure than no account that needs adjustment at year-end is overlooked. In this situation, interest expense is $55,250 (see Figure 9-1). The sum of the business’s two notes payable accounts in the year-end listing of accounts is $850,000. From Figure 9-1, you don’t know for sure whether these two notes payable were borrowed for the entire year. Assuming that the notes were outstanding the entire year, the following applies: $55,250 interest expense ÷ $850,000 notes payable = 6.5 percent annual interest rate If the notes payable were outstanding for less than the full year, then the effective annual interest rate would be higher. Ultimately, the interest expense account probably doesn’t need adjusting at the end of the year. The business probably has recorded all interest expense for the year, so it’s unlikely that an adjusting entry needs to be recorded at year-end for interest expense. b In Figure 9-1 the Owners’ Equity — Retained Earnings account has a zero balance. Why? The final entry of the year is the closing entry in which the net profit or loss for the year is entered into the retained earnings account. The closing entry isn’t made until all expenses for the year are recorded. Because the business has just concluded its first year, its retained earnings account had a zero balance at the start of the year. The closing entry to transfer net profit or loss for the year into the account hasn’t been made, so retained earnings still has a zero balance. After the accountant records net profit or loss into retained earnings, the account will have a balance, of course. c In Figure 9-1, note the Prepaid Expenses asset account at the end of the year. What are three examples of such prepaid costs? Are the methods for allocating these costs to expense fairly objective and noncontroversial? Three examples of prepaid expenses are: • Insurance premiums: Paid in advance of the insurance coverage. When the premium is paid, the amount is recorded in the prepaid expenses asset account and then the cost is allocated to each month of insurance coverage. • Office and operating supplies: Bought in quantities that last several months. The cost of these purchases is recorded in the prepaid expenses asset account and then allocated to expense as the supplies are used. • Property taxes: Paid at the beginning of the tax year in some states, counties, and cities. The tax paid for the coming year is recorded in the prepaid expenses asset account and then allocated to property tax expense each month or quarter. Generally speaking, the allocation of these and other prepaid expenses is objective and noncontroversial. Different accountants use the same allocation methods. However, most businesses don’t bother to record relatively minor prepaid costs in the asset account and instead record the costs immediately as expenses. For example, a business may give its delivery truck drivers quarters to feed parking meters as they make deliveries to customers. Theoretically, the amount shouldn’t be recorded as an expense until the quarters are actually used, but most companies record the expense as soon as they distribute the quarters. More free books @ www.BingEbook.com Chapter 9: Choosing Accounting Methods d In Figure 9-1, note the Accrued Expenses Payable liability account at the end of the year. What are three examples of such accrued costs? Are the methods for allocating these costs to expense fairly objective and noncontroversial? Three examples of accrued costs are: • Vacation and sick pay: Businesses should accrue the costs of vacation and sick pay that are “earned” by their employees each pay period. (I stress the word “earned” because the actual accumulation of these employee benefits may not be clear-cut and definite. If the business has a collective bargaining contract with its employees these benefits usually are welldefined.) • Warranties and guarantees: Most products sold by businesses come with a warranty or guarantee. After the point of sale, the business incurs costs to service, repair, or replace a product under the terms of its warranty or guarantee. The business should forecast the future costs of fulfilling these obligations. • Property taxes: The business should determine the amount of the property taxes that are paid at the end of the tax year (in arrears) and accumulate the expense during the year. The accrual of these and other costs isn’t cut and dried and tends to be somewhat controversial. The allocation of accrued costs has many shades of gray — there aren’t any “bright” lines to delineate which particular costs should be accrued and which ones don’t have to be. e During its first year, a business made seven acquisitions of a product that it sells. Figure 9-3 presents the history of these purchases. Compare the purchases history in Figure 9-3 with the one in Figure 9-2. Does the average cost method make more sense or seem more persuasive in one case over the other? This is a hard question to answer, to be frank, because the appropriateness of the average cost method depends on how you look at it. You could argue that you have a little more reason to use the average cost method in the Figure 9-3 scenario because the purchase price bounces up and down, whereas in the Figure 9-2 scenario, the purchase prices are on an upward trend. But, by and large, accountants do not consider whether prices fluctuate up and down or are on a steady up escalator in making the decision to use the average cost method. Accountants like the “leveling out” effect of the average cost method. This is main reason why they prefer the method. f Refer to the purchase history in Figure 9-3. The bookkeeper said he was using the average cost method. He calculated the average of the seven purchase costs per unit and multiplied this average unit cost by the 158,100 units sold during the year. His average cost per unit is $24.76 (rounded). Is this the correct way to apply the average cost method? If not, what is the correct answer for cost of goods sold expense for the year? The bookkeeper made a mistake because the average cost method doesn’t use the simple average of purchases prices. The average cost method uses the weighted average of acquisition prices, which means that each purchase price is weighted by the quantity bought at that price. In the Figure 9-3 scenario, the $26.15 purchase price carries much less weight because only 6,100 units were bought at this price. The $23.05 purchase price carries more weight because 36,500 units were bought at this price. The correct average cost per unit is calculated as follows: ($4,493,140 total cost of purchases ÷ 186,000 units purchased) = $24.1567, or $24.16 rounded Therefore, the correct cost of goods sold expense for the period is $3,819,169. You can calculate this amount by multiplying the exact average cost per unit by the 158,100 units sold, or you can calculate it as follows: (158,100 units sold ÷ 186,000 units available for sale) × $4,493,140 total cost of goods available for sale = $3,819,169 cost of goods sold expense 195 More free books @ www.BingEbook.com 196 Part II: Preparing Financial Statements g Figure 9-3 presents the inventory acquisition history of a business for its first year. The business sold 158,100 units during the year. By the FIFO method, determine its cost of goods sold expense for the year and its cost of ending inventory. The cost of goods sold expense by the FIFO method is determined as follows: Quantity Per Unit First purchase 14,200 Units $25.75 $365,650 Second purchase 42,500 Units $23.85 $1,013,625 Third purchase 16,500 Units $24.85 $410,025 Fourth purchase 36,500 Units $23.05 $841,325 Fifth purchase 6,100 Units $26.15 $159,515 Sixth purchase 42,300 Units $23.65 $1,000,395 Source Totals Cost $3,790,535 158,100 Units The cost of ending inventory includes some units from the sixth purchase and all units from the seventh purchase, which is summarized in the following schedule: h Per Unit Source Quantity Sixth purchase 9,700 Units $23.65 $229,405 Seventh purchase 18,200 Units $26.00 $473,200 Totals 27,900 Units Cost $702,605 In the example shown in Figure 9-3, the purchase cost per unit bounces up and down over successive acquisitions, and the quantities purchased each time vary quite a bit. Do these two factors play a role in the choice of a cost of goods sold method? Generally speaking, the volatility of acquisition costs per unit isn’t a critical factor in choosing a cost of goods sold expense method, nor is the variation in acquisition quantities. The reasons for selecting one method over another don’t depend on these two factors. i Figure 9-3 presents the inventory acquisition history of a business for its first year. The business sold 158,100 units during the year. By the LIFO method, determine its cost of goods sold expense for the year and its cost of ending inventory. The cost of goods sold expense as determined by the LIFO is as follows: Source Quantity Per Unit Seventh purchase 18,200 Units $26.00 $473,200 Sixth purchase 52,000 Units $23.65 $1,229,800 Fifth purchase 6,100 Units $26.15 $159,515 Fourth purchase 36,500 Units $23.05 $841,325 Third purchase 16,500 Units $24.85 $410,025 Second purchase 28,800 Units $23.85 Totals Cost $686,880 $3,800,745 158,100 Units The cost of ending inventory includes all the units from the first purchase and some from the second purchase, which is summarized as follows: Source j Quantity Per Unit Sixth purchase 13,700 Units $23.85 $326,745 Seventh purchase 14,200 Units $25.75 $365,650 Totals 27,900 Units Cost $692,395 Suppose the business whose inventory acquisition history appears in Figure 9-3 sold all 186,000 More free books @ www.BingEbook.com Chapter 9: Choosing Accounting Methods units that it had available for sale during the year. In this situation, does the business’s choice of cost of goods sold expense method make any difference? No, all three methods (average cost, FIFO, and LIFO) give the same result. The $4,493,140 total purchase cost of the 186,000 units would be charged to cost of goods sold expense. k Determine the annual depreciation amounts on the machines for years two through seven according to the double declining method. Also, determine the book value (cost less accumulated depreciation) at the end of each year. The complete depreciation schedule of the machines over their estimated seven years of life is presented as follows: Year Cost less Accumulated Depreciation at Start of Year Annual Depreciation Fraction Applied on Declining Balance 1 $532,000 $152,000 2/7 2 $380,000 $108,571 2/7 3 $271,429 $77,551 2/7 4 $193,878 $55,394 2/7 5 $138,484 $46,161 See Note 6 $92,323 $46,161 See Note 7 $46,161 $46,161 See Note Total $532,000 Note: The $138,484 balance at the start of Year 5 is allocated to years 5, 6, and 7 by straight-line method. Note the “Cost less Accumulated Depreciation at Start of Year” column in the schedule. These are the book values of the asset at the start of each year, which are the same as the book value at the end of the previous year. For instance, the $380,000 book value at the start of year 2 is the same as the book value at the end of year 1. And so on. At the end of year 7 the book value is down to zero, because the $532,000 accumulated depreciation equals the original cost of the asset. l m Instead of using the double-declining depreciation method for its machines, suppose the business used the straight-line depreciation method over seven years. Determine the year-by-year difference in bottom-line profit with the straight-line depreciation method. (Remember that the business doesn’t pay income tax because it’s a pass-through tax entity.) Year Double Declining Depreciation Straight-line Depreciation Net Income Difference Using Straight-line Depreciation 1 $152,000 $76,000 $76,000 2 $108,571 $76,000 $32,571 3 $77,551 $76,000 $1,551 4 $55,394 $76,000 ($20,606) 5 $46,161 $76,000 ($29,839) 6 $46,161 $76,000 ($29,839) 7 $46,161 $76,000 ($29,839) Totals $532,000 $532,000 $0 The chief accountant of the business outlined in the example question is from the doublebreasted, dull grey suit, old guard school of accounting. He argues that a customer’s account receivable should be written off as uncollectible when it becomes more than 30 days old. The normal credit term offered by the business to customers is 30 days. At the end of its first year, $278,400 of the company’s $645,000 accounts receivable is more than 30 days old. What bad debts expense entry would the chief accountant make if he had his way at the end of the year? Do you agree with his approach? 197 More free books @ www.BingEbook.com 198 Part II: Preparing Financial Statements If the chief accountant had his way, he would make the following entry: Bad Debts Expense $278,400 Accounts Receivable $278,400 I certainly don’t agree with writing off such a large amount of accounts receivable. In the real world of business, many customers don’t pay on time; indeed, late payment by some customers is expected any time credit’s extended. The business would like to receive all payments for its credit sales on time, of course, but it knows that many of its customers probably won’t make their payments within 30 days. The chief accountant needs to get real and understand that many customers slip beyond the 30-day credit period but eventually pay for their purchases. n The president of the business outlined in the example question attends an industry update seminar at which the speaker says that the average bad debts experience of businesses in this field is about 1 percent of sales. Assume the business adopts this method. Determine its bad debts expense for the first year and for the balances in its accounts receivable and allowance for doubtful accounts at the end of the year. The year-end adjusting entry is as follows: Bad Debts Expense $45,850 Allowance for Doubtful Accounts $45,850 To record bad debts expense equal to 1.0% of total sales for year. The business also records the write off specific customers’ accounts that have been identified as uncollectible. The write-off entry is as follows: Allowance for Doubtful Accounts $18,500 Accounts Receivable $18,500 To record write off of uncollectible accounts. Based on the information provided in the example, using 1 percent of sales to estimate bad debts expense seems too high for this particular business. And, as I mention in the chapter, the IRS doesn’t allow the allowance method for income tax purposes. o Prepare the company’s income statement for its first year of business using the conservative accounting methods for cost of goods sold expense, depreciation expense, and bad debts expense. Using LIFO for cost of goods sold expense, accelerated depreciation for machines, and the allowance method for bad debts expense, the income statement of the business for its first year is as follows: Income Statement for First Year Sales Revenue $4,585,000 Cost of Goods Sold Expense: Beginning inventory $0 Purchases $3,725,000 Available for sale $3,725,000 Ending inventory $708,000 Gross Profit Depreciation expense Bad debts expense Selling and General Expenses Operating Profit before Interest Interest Expense Net Income p $3,017,000 $1,568,000 $164,000 $38,500 $1,033,000 $1,235,500 $332,500 $55,250 $277,250 Prepare the company’s income statement for its first year of business using the liberal account- More free books @ www.BingEbook.com Chapter 9: Choosing Accounting Methods ing methods for cost of goods sold expense, depreciation expense, and bad debts expense. Using FIFO for cost of goods sold expense, straight-line depreciation for machines, and the specific charge off method for bad debts expense, the income statement of the business for its first year is as follows: Income Statement for First Year Sales Revenue $4,585,000 Cost of Goods Sold Expense: Beginning inventory $0 Purchases $3,725,000 Available for sale $3,725,000 Ending inventory $800,000 Gross Profit Depreciation expense Bad debts expense Selling and General Expenses Operating Profit before Interest Interest Expense Net Income $2,925,000 $1,660,000 $88,000 $18,500 $1,033,000 $1,139,500 $520,500 $55,250 $465,250 For additional insight, compare the net income in your answer using liberal accounting methods to your answer to Question 15, which asks you to use conservative accounting methods. You’ll find that net income is $188,000 higher using liberal accounting methods, or 68 percent higher than the profit determined by using conservative accounting methods in Question 15. 199 More free books @ www.BingEbook.com 200 Part II: Preparing Financial Statements More free books @ www.BingEbook.com Part III Managerial, Manufacturing, and Capital Accounting