The adjusting entry to recognize the accrued salary expense is a claims exchange transaction. One claims account, Retained Earnings, decreases and another claims account, Salaries Payable, increases. The expense recognition reduces net income. The statement of cash flows is not affected. The effects of this transaction on the financial statements are shown here.
CHECK Yourself 2.3
Sanderson & Associates received a $24,000 cash advance as a retainer to provide legal services to a client. The contract called for Sanderson to render services during a one- year period beginning October 1, 2010. Based on this information alone, determine the cash flow from operating activities Sanderson would report on the 2010 and 2011 state- ments of cash flows. Also determine the amount of revenue Sanderson would report on the 2010 and 2011 income statements.
Answer Since Sanderson collected all of the cash in 2010, the 2010 statement of cash flows would report a $24,000 cash inflow from operating activities. The 2011 statement of cash flows would report zero cash flow from operating activities. Revenue is recog- nized in the period in which it is earned. In this case revenue is earned at the rate of
$2,000 per month ($24,000 4 12 months 5 $2,000 per month). Sanderson rendered serv- ices for three months in 2010 and nine months in 2011. Sanderson would report $6,000 (3 months 3 $2,000) of revenue on the 2010 income statement and $18,000 (9 months 3
$2,000) of revenue on the 2011 income statement.
Summary of Events
The previous section of this chapter described sixteen events Cato Consultants expe- rienced the during the 2011 accounting period. These events are summarized below for your convenience.
Event 1 Cato paid $6,000 to the instructor to settle the salaries payable obligation.
Event 2 On March 1, Cato paid $12,000 cash to lease office space for one year.
Event 3 Cato received $18,000 cash in advance from Westberry Company for con- sulting services to be performed for one year beginning June 1.
Event 4 Cato purchased $800 of supplies on account.
Event 5 Cato provided $96,400 of consulting services on account.
Event 6 Cato collected $105,000 cash from customers as partial settlement of ac- counts receivable.
Assets 5 Liab. 1 Stk. Equity
Sal. Pay. 1 Ret. Earn. Rev. 2 Exp. 5 Net Inc. Cash Flow NA 5 4,000 1 (4,000) NA 2 4,000 5 (4,000) NA
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Understanding the Accounting Cycle 59
Event 7 Cato paid $32,000 cash for salary expense.
Event 8 Cato incurred $21,000 of other operating expenses on account.
Event 9 Cato paid $18,200 in partial settlement of accounts payable.
Event 10 Cato paid $79,500 to purchase land it planned to use in the future as a build- ing site for its home office.
Event 11 Cato paid $21,000 in cash dividends to its stockholders.
Event 12 Cato acquired $2,000 cash from issuing additional shares of common stock.
The year-end adjustments are:
Event 13 After determining through a physical count that it had $150 of unused sup- plies on hand as of December 31, Cato recognized supplies expense.
Event 14 Cato recognized rent expense for the office space used during the accounting period.
Event 15 Cato recognized the portion of the unearned revenue it earned during the accounting period.
Event 16 Cato recognized $4,000 of accrued salary expense.
Because the Meredith Corporation receives cash from customers before actually providing any magazines to them, the company has not earned any revenue when it receives the cash. Thus, Meredith has a liability called unearned revenue. If it closed its books on December 31, then $3 of Sarah’s subscription would be recognized as revenue in 2010. The remain- ing $9 would appear on the balance sheet as a liability.
Meredith Corporation actually ends its accounting year on June 30 each year. A copy of a recent bal- ance sheet for the company is presented in Exhibit 2.6. The liability for unearned subscription revenue was
$239.8 ($127.4 1 $112.4) million—which represented about 28.5 percent of Meredith’s total liabilities!
Will Meredith need cash to pay these subscription liabilities? Not exactly. The liabilities will not be paid directly with cash. Instead, they will be satisfied by providing magazines to the subscribers. However, Meredith will need cash to pay for producing and distributing the magazines supplied to the customers. Even so, the amount of cash required to provide magazines will probably differ significantly from the amount of unearned revenues. In most cases, subscription fees do not cover the cost of producing and distributing magazines. By collecting significant amounts of advertising revenue, publishers can provide magazines to customers at prices well below the cost of publication. The amount of unearned revenue is not likely to coincide with the amount of cash needed to cover the cost of satisfying the company’s obligation to produce and distribute magazines.
Even though the association between unearned revenues and the cost of providing magazines to customers is not direct, a knowledgeable financial analyst can use the information to make estimates of future cash flows and revenue recognition.
Answers to The Curious Accountant
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60 Chapter 2
EXHIBIT 2.6 Balance Sheet for Meredith Corporation CONSOLIDATED BALANCE SHEETS
Meredith Corporation and Subsidiaries As of June 30 (amounts in thousands) Assets
Current assets
Cash and cash equivalents $ 29,788
Accounts receivable (net of allowances of $15,205) 176,669
Inventories 41,562
Current portion of subscription and acquisition costs 27,777
Current portion of broadcast rights 13,539
Other current assets 15,160
Total current assets 304,495 Property, plant and equipment
Land 19,261
Buildings and improvements 106,112
Machinery and equipment 256,380
Leasehold improvements 8,863
Construction in progress 8,266
Total property, plant and equipment 398,882
Less accumulated depreciation (205,926)
Net property, plant and equipment 192,956
Subscription acquisition costs 24,722
Broadcast rights 7,096
Other assets 58,589
Intangibles, net 707,068
Goodwill 196,382
Total assets $1,491,308 Liabilities and Shareholders’ Equity
Current liabilities
Current portion of long-term debt $ 125,000
Current portion of long-term broadcast rights payable 18,676
Accounts payable 48,462
Accrued expenses
Compensation and benefits 42,162
Distribution expenses 17,546
Other taxes and expenses 59,818
Total accrued expenses 119,526
Current portion of unearned subscription revenues 127,416
Total current liabilities 439,080
Long-term debt 125,000
Long-term broadcast rights payable 17,208
Unearned subscription revenues 112,358
Deferred income taxes 93,929
Other noncurrent liabilities 51,906
Total liabilities 839,481 Shareholders’ equity
Common stock, par value $1 per share 39,700
Class B stock, par value $1 per share, convertible to common stock 9,596
Additional paid-in capital 55,346
Retained earnings 550,115
Accumulated other comprehensive loss (1,025)
Unearned compensation (1,905)
Total shareholders’ equity 651,827 Total liabilities and shareholders’ equity $1,491,308
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Understanding the Accounting Cycle 61
The General Ledger
Exhibit 2.7 shows Cato Consultants’ 2011 transaction data recorded in general ledger form. The account balances at the end of 2010, shown in Exhibit 2.3, become the beginning balances for the 2011 accounting period. The 2011 transaction data are referenced to the accounting events with numbers in parentheses. The information in the ledger accounts is the basis for the financial statements in Exhibit 2.8. Before reading further, trace each event in the summary of events into Exhibit 2.7.
Organize general ledger accounts under an accounting equation.
LO 2
Vertical Statements Model
Financial statement users obtain helpful insights by analyzing company trends over multiple accounting cycles. Exhibit 2.8 presents for Cato Consultants a multicycle vertical statements model of 2010 and 2011 accounting data. To conserve space, we
EXHIBIT 2.7
Ledger Accounts with 2011 Transaction Data
Assets 5 Liabilities 1 Stockholders’ Equity Prepaid Rent
Bal. 0 (2) 12,000 (14) (10,000) Bal. 2,000
Land Bal. 0 (10) 79,500 Bal. 79,500 Cash
Bal. 53,000 (1) (6,000) (2) (12,000) (3) 18,000 (6) 105,000 (7) (32,000) (9) (18,200) (10) (79,500) (11) (21,000) (12) 2,000 Bal. 9,300 Accounts Receivable Bal. 24,000 (5) 96,400 (6) (105,000) Bal. 15,400
Supplies Bal. 0 (4) 800 (13) (650) Bal. 150
Accounts Payable Bal. 0 (4) 800 (8) 21,000 (9) (18,200) Bal. 3,600
Unearned Revenue Bal. 0 (3) 18,000 (15) (10,500) Bal. 7,500
Salaries Payable Bal. 6,000 (1) (6,000) (16) 4,000 Bal. 4,000
Common Stock Bal. 5,000 (12) 2,000 Bal. 7,000
Retained Earnings Bal. 66,000
Dividends Bal. 0 (11) (21,000) Bal. (21,000) Consulting Revenue Bal. 0 (5) 96,400 (15) 10,500 Bal. 106,900
Other Operating Expenses Bal. 0 (8) (21,000) Bal. (21,000)
Salary Expense Bal. 0 (7) (32,000) (16) (4,000) Bal. (36,000)
Rent Expense Bal. 0 (14) (10,000) Bal. (10,000)
Supplies Expense Bal. 0 (13) (650) Bal. (650)
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62 Chapter 2
have combined all the expenses for each year into single amounts labeled “Operating Expenses,” determined as follows.
Similarly, we combined the cash payments for operating expenses on the statement of cash flows as follows.
2010 2011
Other operating expenses $ 0 $21,000 Salary expense 16,000 36,000
Rent expense 0 10,000
Advertising expense 2,000 0
Supplies expense 0 650
Total operating expenses $18,000 $67,650 Explain how business events affect
financial statements over multiple accounting cycles.
LO 6
Recall that the level of detail reported in financial statements depends on user information needs. Most real-world companies combine many account balances together to report highly summarized totals under each financial statement caption.
Before reading further, trace the remaining financial statement items from the ledger accounts in Exhibit 2.7 to where they are reported in Exhibit 2.8.
The vertical statements model in Exhibit 2.8 shows significant interrelationships among the financial statements. For each year, trace the amount of net income from the income statement to the statement of changes in stockholders’ equity. Next, trace the ending balances of common stock and retained earnings reported on the state- ment of changes in stockholders’ equity to the stockholders’ equity section of the balance sheet. Also, confirm that the amount of cash reported on the balance sheet equals the ending cash balance on the statement of cash flows.
Other relationships connect the two accounting periods. For example, trace the ending retained earnings balance from the 2010 statement of stockholders’ equity to the beginning retained earnings balance on the 2011 statement of stockholders’ equity.
Also, trace the ending cash balance on the 2010 statement of cash flows to the begin- ning cash balance on the 2011 statement of cash flows. Finally, confirm that the change in cash between the 2010 and 2011 balance sheets ($53,000 2 $9,300 5 $43,700 decrease) agrees with the net change in cash reported on the 2011 statement of cash flows.
2010 2011
Supplies and other operating expenses $ 0 $18,200*
Salary expense 10,000 38,000
Rent expense 0 12,000
Advertising expense 2,000 0
Total cash payments for operating expenses $12,000 $68,200
*Amount paid in partial settlement of accounts payable
EXHIBIT 2.8 Vertical Statements Model CATO CONSULTANTS
Financial Statements Income Statements For the Years Ended December 31
2010 2011
Consulting revenue $84,000 $106,900
Operating expenses (18,000) (67,650)
Net income $66,000 $ 39,250
continued
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Understanding the Accounting Cycle 63
EXHIBIT 2.8 Concluded
Statements of Changes in Stockholders’ Equity For the Years Ended December 31
2010 2011
Beginning common stock $ 0 $ 5,000
Plus: Common stock issued 5,000 2,000
Ending common stock 5,000 7,000
Beginning retained earnings 0 66,000
Plus: Net income 66,000 39,250
Less: Dividends 0 (21,000)
Ending retained earnings 66,000 84,250
Total stockholders’ equity $71,000 $ 91,250 Balance Sheets
As of December 31
2010 2011
Assets
Cash $53,000 $ 9,300
Accounts receivable 24,000 15,400
Supplies 0 150
Prepaid rent 0 2,000
Land 0 79,500
Total assets $77,000 $106,350
Liabilities
Accounts payable $ 0 $ 3,600
Unearned revenue 0 7,500
Salaries payable 6,000 4,000
Total liabilities 6,000 15,100
Stockholders’ equity
Common stock 5,000 7,000
Retained earnings 66,000 84,250
Total stockholders’ equity 71,000 91,250
Total liabilities and stockholders’ equity $77,000 $106,350 Statements of Cash Flows
For the Years Ended December 31
2010 2011
Cash Flows from Operating Activities
Cash receipts from customers $60,000 $123,000 Cash payments for operating expenses (12,000) (68,200) Net cash flow from operating activities 48,000 54,800 Cash Flows from Investing Activities
Cash payment to purchase land 0 (79,500)
Cash Flows from Financing Activities
Cash receipts from issuing common stock 5,000 2,000
Cash payments for dividends 0 (21,000)
Net cash flow from financing activities 5,000 (19,000)
Net change in cash 53,000 (43,700)
Plus: Beginning cash balance 0 53,000
Ending cash balance $53,000 $ 9,300
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64 Chapter 2
CHECK Yourself 2.4
Treadmore Company started the 2010 accounting period with $580 of supplies on hand.
During 2010 the company paid cash to purchase $2,200 of supplies. A physical count of supplies indicated that there was $420 of supplies on hand at the end of 2010. Treadmore pays cash for supplies at the time they are purchased. Based on this information alone, determine the amount of supplies expense to be recognized on the income statement and the amount of cash flow to be shown in the operating activities section of the statement of cash flows.
Answer The amount of supplies expense recognized on the income statement is the amount of supplies that were used during the accounting period. This amount is com- puted below.
Beginning Supplies Supplies Ending Supplies balance 1 purchased 5 available 2 balance 5 used $580 1 $2,200 5 $2,780 2 $420 5 $2,360
The cash flow from operating activities is the amount of cash paid for supplies during the accounting period. In this case, Treadmore paid $2,200 cash to purchase supplies. This amount would be shown as a cash outflow.
CORPORATE GOVERNANCE
Corporate governance is the set of relationships between the board of directors, man- agement, shareholders, auditors, and other stakeholders that determines how a com- pany is operated. Clearly, financial analysts are keenly interested in these relationships.
This section discusses the key components of corporate governance.
Importance of Ethics
The accountant’s role in society requires trust and credibility. Accounting information is worthless if the accountant is not trustworthy. Similarly, tax and consulting advice is useless if it comes from an incompetent person. The high ethical standards required by the profession state “a certified public accountant assumes an obligation of self-discipline above and beyond requirements of laws and regulations.” The American Institute of Certified Public Accountants requires its members to comply with the Code of Professional Conduct. Section I of the Code includes six articles that are summarized in Exhibit 2.9.
The importance of ethical conduct is universally recognized across a broad spectrum of accounting organizations. The Institute of Management Accountants requires its mem- bers to follow a set of Standards of Ethical Conduct. The Institute of Internal Auditors also requires its members to subscribe to the organization’s Code of Ethics.
Sarbanes-Oxley Act of 2002
Credible financial reporting relies on a system of checks and balances. Corporate management is responsible for preparing financial reports while outside, independent accountants (CPAs) audit the reports. The massive surprise bankruptcies of Enron in late 2001 and WorldCom several months later suggested major audit failures on the part of the independent auditors. An audit failure means a company’s auditor does THE FINANCIAL ANALYST
Identify the primary components of corporate governance.
LO 7
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Understanding the Accounting Cycle 65
not detect, or fails to report, that the company’s financial reports are not in compliance with GAAP. The audit failures at Enron, WorldCom, and others prompted Congress to pass the Sarbanes-Oxley Act (SOX), which became effective on July 30, 2002.
Prior to SOX, independent auditors often provided nonaudit services, such as installing computer systems, for their audit clients. The fees they earned for these services sometimes greatly exceeded the fees charged for the audit itself. This practice had been questioned prior to the audit failures at Enron and WorldCom. Critics felt the independent audit firm was subject to pressure from the company to conduct a less rigorous audit, or risk losing lucrative nonaudit work. To strengthen the audit function SOX included the following provisions.
■ Prior to the enactment of SOX, independent auditors were self-regulated by the membership of the American Institute of Certified Public Accountants and by state boards of accountancy. Beyond self-regulation, SOX establishes The Public Company Accounting Oversight Board (PCAOB) to regulate accounting profes- sionals that audit the financial statements of public companies.
■ Independent auditors must register with the PCAOB or cease all participation in public company audits and abide by the board’s pronouncements.
■ The PCAOB will conduct inspections of registered firms. To ensure enforcement, the board has a full range of sanctions at its disposal, including suspension or revocation of registration, censure, and significant fines.
■ To reduce the likelihood of conflicts of interest, SOX prohibits all registered public accounting firms from providing audit clients, contemporaneously with the audit, certain nonaudit services, including internal audit outsourcing, financial- information-system design and implementation services, and expert services.
■ SOX provides for significant corporate governance reforms regarding audit com- mittees and their relationship to the auditor, making the audit committee respon- sible for the appointment, compensation, and oversight of the issuer’s auditor.
EXHIBIT 2.9
Articles of AICPA Code of Professional Conduct
Article I Responsibilities
In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities.
Article II The Public Interest
Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.
Article III Integrity
To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.
Article IV Objectivity and Independence
A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.
Article V Due Care
A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability.
Article VI Scope and Nature of Services
A member in public practice should observe the principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.
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66 Chapter 2
Other provisions of SOX clarify the legal responsibility that company manage- ment has for a company’s financial reports. The company’s chief executive officer (CEO) and chief financial officer (CFO) must certify in writing that they have reviewed the financial reports being issued, and that the reports present fairly the company’s financial status. An executive who falsely certifies the company’s financial reports is subject to a fine up to $5 million and imprisonment up to 20 years.
Common Features of Criminal and Ethical Misconduct
Unfortunately, it takes more than a code of conduct to stop fraud. People frequently engage in activities that they know are unethical or even criminal. The auditing profession has identified three elements that are typically present when fraud occurs.
1. The availability of an opportunity.
2. The existence of some form of pressure leading to an incentive.
3. The capacity to rationalize.
Ethical conduct is shaped by the cultural climate. Indeed, a business culture that focuses narrowly on shareholder interest is frequently blamed for the excesses that led to the downfall of Enron and others. The mantra was an ever-increasing stock price. Incentive packages encourage executives to take short cuts or even engage in fraudulent behavior in order to “make the numbers.” The infamous quote of Gordon Gekko in the 1987 movie Wall Street—“Greed is Good”—
epitomized a culture of self-indul- gence. Gekko’s quote was drawn from Sun Tzu’s management treatise The Art of War. This treatise contained the tenets that guided corporate govern- ance in the 1980s and 90s.
In the aftermath of the massive corporate scandals, a new view of corporate responsibility is emerg- ing. Many leading business schools have recruited Indian educators who
hold a much broader view of corporate responsibility. Their teachings are based on the Hindu text Bhagavad Gita, which focuses on thoughts and actions, rather than outcomes. These educators urge executives to be motivated by a broader purpose than money. They advocate a more holistic approach to business—one that takes into account the needs of shareholders, employees, customers, society, and the environment as well as the shareholders. This view has been called “Karma Capitalism.”
Karma Capitalism is a gentler, more empathetic approach to business. It advances concepts such as “emotional intelligence”
and “servant leadership.” BusinessWeek observes manifestations such as “where once corporate philanthropy was an obliga- tion, these days it’s fast becoming viewed as a competitive advantage for attracting and retaining top talent.” Where the rally- ing cry in the 1980s and 90s may have been “greed is good,” today it’s becoming “green is good.” Certainly, this new zeitgeist is more supportive of moral conduct than a culture based largely on self-interest.
The contrasting philosophies are summarized above under the heading “Dueling Playbooks.”
Focus On INTERNATIONAL ISSUES
GREED IS GOOD. Troops have to see there is
“advantage from defeating the enemy’’ in order to be motivated. Share the booty with the rank and file, and give them shares of conquered territory.
BE TOUGH. Sun Tzu calls for “iron discipline’’:
If you indulge troops with too much kindness and don’t maintain your authority, they’ll be
“useless for any practical purpose.’’
ATTACK ONLY WHEN VICTORY IS LIKELY.
Better yet, maneuver to win without a fight.
If the odds are bad, retreat and wait for another opportunity. Long campaigns strain resources and make you vulnerable.
BEAT THE ENEMY. War is a vital fact of life that “cannot be neglected by a responsible sovereign.’’ Winning requires clever tactics and, in some cases, deception.
GREED IS BAD. “You should never engage in action only for the desire of rewards,” Krishna says. Acting on worldly desires leads to failure.
Do well, and good things will come.
BE FAIR. Enlightened leaders are compassionate and selfless, and they “treat everyone as their equals.’’ Followers will rally around them and follow their example.
ACT RATHER THAN REACT. A leader’s actions today can become the “karma’’ that influences his status tomorrow. Leaders accomplish
“excellence by taking action,’’ Krishna says.
SEEK HIGHER CONSCIOUSNESS. Leaders should view problems within their larger contexts. Translation:
Show sensitivity to multiple stakeholders including shareholders, employees, partners, and neighbors.
Dueling Playbooks
The opposing best-practice ideas of Sun Tzu and Krishna
ON FINANCIAL INCENTIVES
ON MANAGING UNDERLINGS
INITIATIVEON
ON THE ULTIMATE GOAL To Sun Tzu, author of the once-hip management
treatise The Art of War, victory should be the “great object.’’ Winning the battle is all about unyielding discipline. Some of Sun Tzu’s key ideas:
The Bhagavad Gita, a Hindu text more in keeping with today’s zeitgeist, contains the wisdom of Lord Krishna. Focus on your thoughts and actions, rather than the outcome. Krishna’s take:
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