From David H. Marshal and Wayne W. McManus.  Accounting. 

It is not unusual for a new corporation that wants to expand its operations to form a separate corporation to carry out its plans. In such a case the original corporation owns all of the stock of the new corporation; it has become the "parent" of a "subsidiary." One parent may have several subsidiaries, and the subsidiaries themselves may be parents of subsidiaries. It is not necessary for the parent to own 100% of the stock of another corporation for the parent-subsidiary relationship to exist. If one corporation owns more than half of the stock of another, it is presumed that the majority owner can exercise enough control to create a parent-subsidiary relationship. When a subsidiary is not wholly owned, the other stockholders of the subsidiary are referred to as minority stockholders.

In most instances, the financial statements issued by the parent corporation will include the assets, liabilities, owners' equity, revenues, expenses, and gains and losses of the subsidiaries. Financial statements that reflect the financial position, results of operations, and cash flows of a parent and one or more subsidiaries are calledconsolidated financial statements.

if a parcel of land were purchased by a firm for $8,600 even though an appraisal showed the land to be worth $10,000, the purchase transaction would be reflected in the accounting records, and the financial statements would report the land at its cost of $8,600. If the land is still owned and being used 15 years later, even though its market value has increased to $80,000, it continues to be reported in the balance sheet at its original cost of $8,600.

Objectivity refers to accountants' desire to have a given transaction recorded in the same way in all situations. This objective is facilitated by using the dollar as the unit of measurement, and by applying the cost principle. However, as previously stressed, there are transactions for which the exercise of professional judgment could result in alter­native recording results. These alternatives will be illustrated in sub­sequent chapters.

Concepts/Principles Related to Bookkeeping Procedures and the Accounting Process

These concepts/principles relate to the accounting period that is, the period of time selected for reporting results of operations and changes in financial position. Financial position will be reported at the end of this period of time (and the balance sheet at the beginning of the period will probably be included with the financial statements). For most entities, the accounting period will be one year in length.

Matching revenue and expense is necessary if the results of the firm's operations are to reflect accurately its economic activities during the period. The matching concept does not mean that reve­nues and expenses for a period are equal. Revenue is not earned without effort (businesses do not receive birthday gifts), and expenses are the measure of the economic efforts exerted to generate revenues. A fair presentation of the results of a firm's operations during a period of time requires that all expenses incurred in generating that period's revenues be deducted from the revenues earned. This results in an accurate measure of the net income or net loss for the period. This seems like common sense, but, as we shall see, there are alterna­tive methods of determining some of the expenses to be recognized in any given period. This concept of matching revenue and expense is very important, and will be referred to again and again as accounting practices are discussed in the following chapters.

Revenue is recognized at the time of sale, which is when title to the product being sold passes from the seller to the buyer, or when the services involved in the transaction have been performed. Passing of legal ownership (title) is the critical event, not the cash payment from buyer to seller.

Accrual accounting utilizes the accrual concept, and results in recognizing revenue at the point of sale and recognizing expenses as they are incurred, even though the cash receipt or payment occurs at another time or in another accounting period. Thus, many activities of the firm will involve two transactions: one that recognizes the revenue or expense, and the other that reflects the receipt or payment of cash. It is the use of accrual procedures that accomplishes much of the matching of revenues and expenses because most transactions between business firms (and between many firms and individuals) involve purchase/sale at one point in time and cash payment/receipt at some other point in time.

The financial statement user relies on these concepts and principles related to the accounting period when making judgments and in­formed decisions about an entity's financial position and results of operations.

Concepts/Principles Related to Financial Statements

Consistency in financial reporting is essential if meaningful trend comparisons are to be made using an entity's financial statements for several years. Thus, it is inappropriate for an entity to change from one generally accepted alternative of accounting for a particular type of transaction to another generally accepted method, unless both the fact that the change has been made and the effect of the change on the financial statements are explicitly described in the financial statements or the accompanying notes and explanations.

Full disclosure means that the financial statements and notes or explanations should include all necessary information to prevent a reasonably astute user of the financial statements from being misled. This is a tall order, and one that the Securities and Exchange Commis­sion has helped to define over the years. This requirement for full disclosure is one reason that the notes and explanations are usually considered to be an integral part of the financial statements.

Materiality means that absolute exactness, even if that idea could be defined, is not necessary in the amounts shown in the financial statements. Because of the numerous estimates involved in account­ing, amounts reported in financial statements may be approximate, but they will not be "wrong" enough to be misleading. The financial statements of publicly owned corporations usually show amounts rounded to the nearest thousand, hundred thousand, or even million dollars. This rounding does not impair the information content of the financial statements, and probably makes them easier to read. A management concept related to materiality is the cost-benefit relationship. Just as a manager would not spend $500 to get $300 worth of information, the incremental benefit of increased accuracy in accounting estimates is frequently not worth the cost of achieving the increased accuracy.

Conservatism in accounting relates to making judgments and esti­mates that result in lower profits and asset valuation estimates rather than higher profits and asset valuation estimates. Accountants try to avoid wishful thinking or pie-in-the-sky estimates that could result in overstating profits for a current period. This is not to say that accountants always look at issues from a gloom-and-doom viewpoint; rather, they seek to be realistic, but are conservative when in doubt.

Limitations of Financial Statements

Financial statements report quantitative economic data; they do not reflect qualitative economic variables. Thus, the value to the firm of a management team, or of the morale of the workforce, is not in­cluded as a balance sheet asset because it cannot be objectively measured. Such qualitative attributes of the firm are frequently rele­vant to the decisions and informed judgments that the financial statement user is making, but they are not communicated in the financial statements.

 As already emphasized, the cost principle requires assets to be recorded at their original cost. The balance sheet does not show the current market value or the replacement cost of the assets. Some assets are reported at the lower of their cost or market value, and in some cases market value may be reported parenthetically, but asset values are not increased to reflect current value. For example, the trademark of a firm has virtually no cost; its value has developed over the years as the firm has successfully met customers' needs. Thus, trademarks are usually excluded from the balance sheet listing of assets.

Estimates are used in many areas of accounting, and when the estimate is made, about the only fact known is that the estimate is probably not equal to the "true" amount. It is hoped that the estimate is near the "true" amount (the concept of materiality); it usually is. For example, recognizing depreciation expense involves estimating both the useful life to the entity of the asset being depreciated, and the probable salvage value of the asset to the entity when it is disposed of. The original cost minus the salvage value is the amount to be depreciated or recognized as expense over the asset's life. Estimates must also be made to determine pension expense, warranty costs, and numerous other expense and revenue items to be reflected in the current year's income statement because they reflect the eco­nomic activity of the current year. These estimates also affect balance sheet accounts. So even though the balance sheet balances to the penny, do not be misled by this aura of exactness. Accountants do their best to make their estimates as accurate as possible, but esti­mates are still estimates.

The principle of consistency suggests that an entity should not change from one generally accepted method of accounting for a particular item to another generally accepted method of accounting for the same item. However, it is quite possible that two firms op­erating in the same industry may follow different methods. This means that comparability between firms may not be appropriate, or if comparisons are made, the effects of any differences between the accounting methods followed by the firms must be understood.

Related to the use of the original cost principle is the fact that financial statements are not adjusted to show the impact of inflation. Land acquired by a firm 50 years ago is still reported at its original cost, even though it may have a significantly higher current value because of inflation. Likewise, depreciation expense and the cost of goods sold—both significant expense elements of the income statement of many firms—reflect original cost, not replacement cost. This weakness is not significant when the rate of inflation is low, but the usefulness of financial statements is seriously impaired when the inflation rate rises to double digits. In 1980 the FASB began to

 EXERCISES AND PROBLEMS 2-1.   Identify accounts by category and financial statement(s).

Listed below are a number of financial statement captions. Indicate in the spaces to the right of each caption the category of each item, and the financial statement(s) on which the item can usually be found. Use the following abbreviations:

Category            Financial Statement

Asset                      A       Balance sheet    BS

Liability                 L       Income statement       IS

Owners' equity       OE        Statement of changes

Revenue                 R         in owners' equity       SOE

Expense                 E

Gain                       G

Loss                       LS

Cash                                    _____   _____

Accounts payable                _____   _____

Common stock                    _____   --------

Depreciation expense          _____   _____

Net sales                              _____   --------

Income tax expense             _____   _____

Short-term investments       _____   _____

Gain on sale of land            ___________

Retained earnings                ___________

Dividends payable              ___________

Accounts receivable            ___________

Short-term debt                   ___________

2-2.    Identify accounts by category and financial statement(s).

Listed below are a number of financial statement captions. Indicate in the spaces to the right of each caption the category of each item, and the financial statement(s) on which the item can usually be found. Use the following abbreviations:

Category            Financial Statement

Asset                      A       Balance sheet    BS

Liability                 L       Income statement        IS

Owners' equity       OE        Statement of changes

Revenue                 R         in owners' equity       SOE

Expense                 E

Gain                       G

Loss                       LS

Accumulated depreciation                                            _____

Long-term debt                                                             _____

Equipment                                                                 ______

Loss on sale of

Short-term investments                                              ______

Net income                                                                 ______

Merchandise inventory                                               ______

Other accrued liabilities                                              ______

Dividends paid                                                           ______

Cost of goods sold                                                     ______

Additional paid-in capital                                          ______

Interest income                                                           ______

Selling expenses                                                         ______

2-3.   Understanding financial statement relationships.

The information presented below represents selected data from the De­cember 31, 1996, balance sheets and the income statements for the year then ended, for three different firms.

                                                                                 Firm A Firm В   Firm С

Total assets, 12/31/96....................................... $420,000 $540,000 $325,000

Total liabilities, 12/31/96.................................. 215,000 145,000         ?

Paid-in capital, 12/31/96 ......                              75,000           ? 40,000

Retained earnings, 12/31/96    ...                                  ? 310,000          ?

Net income for 1996.........................................           ?  83,000 113,000

Dividends declared and paid

during 1996...................................................... 50,000  19,000 65,000

Retained earnings, 1/1/96   .    .    .    .                78,000           ? 42,000

Required:                   Calculate the missing amounts for each firm.

2-4.    Understanding financial statement relationships.

The information presented below represents selected data from the De­cember 31, 1996, balance sheets and the income statements for the year then ended, for three different firms.

                                                                                  Firm A        Firm В    Firm С

Total assets, 12/31/96......................................           ?            $460,000         $630,000

Total liabilities, 12/31/96................................. $80,000           ? 270,000

Paid-in capital, 12/31/96..................................         55,000         90,000         140,000

Retained earnings, 12/31/96    ...          ?             186,000                     ?

Net income for 1996.........................................       105,000         84,000         72,000

Dividends declared and paid

during 1996......................................................        20,000           ? 28,000

Retained earnings, 1/1/96   ....        70,000       152,000                       ?

Required:                   Calculate the missing amounts for each firm.

Required

2-5.   Calculate retained earnings.

From the data given below, calculate the Retained Earnings balance as of December 31, 1996.

Retained earnings. December 31, 1995.......... $230,700

Cost of equipment purchased during 1996.... 85,000

Net loss for the year ended December 31, 1996           12,200

Dividends declared and paid in 1996.............    8,000

Decrease in cash balance from January 1, 1996,

to December 31, 1996....................................    6,500

Decrease in long-term debt in 1996................ 31,200

2-6.   Calculate retained earnings.

From the data given below, calculate the Retained Earnings balance as of December 31, 1996.

Retained earnings, December 31, 1997.......... $128,700

Decrease in total liabilities during 1997.........   31,900

Loss on the sale of buildings during 1997......     7,600

Dividends declared and paid in 1997.............   17,700

Proceeds from sale of common stock in 1997   45,000

Net income for the year ended December 31, 1997 .    .    .    .        14,800

2-7.    Calculate dividends using the accounting equation.

At the beginning of its current fiscal year, Radax Corp.'s balance sheet showed assets of $12 and liabilities of $7. During the year, liabilities decreased $1. Net income for the year was $3, and net assets at the end of the year were $6. There were no changes in paid-in capital during the year.

Calculate the dividends, if any, declared during the year. (Hint: Set up an accounting equation for the beginning of the year, changes during the year, and at the end of the year. Enter known data and solve for the unknowns.)Here is a possible worksheet                                       format:

OE

A =   L   + PIC + RE

Beginning:      =        +        +

Changes:                             _ =_ +__ + _

Ending:          =        +        +

2-8.    Calculate net income using the accounting equation.

At the beginning of the current fiscal year, the balance sheet for Dlesk Co. showed liabilities of $468,000. During the year liabilities decreased by $21,000, assets increased by $84,000, and paid-in capital increased from $30,000 to $205,000. Dividends declared and paid during the year were $37,000. At the end of the year, owners' equity totaled $452,000.

Required: Calculate net income (or loss) for the year. (Hint: Set up an accoun equation for the beginning of the year, changes during the year, and at end of the year. Enter known data and solve for the unknowns. Remem, net income (or loss) may not be the only item affecting retained earnin,

2-9.   Calculate cash available upon liquidation of business.

Schindl, Inc., is in the process of liquidating and going out of busini The firm's balance sheet shows $22,800 in cash, inventory totaling $61,4 accounts receivable of $114,200, plant and equipment of $265,000, and tc liabilities of $305,600. It is estimated that the inventory can be disposed in a liquidation sale for 80 percent of its cost, all but 5 percent of t accounts receivable can be collected, and plant and equipment can sold for $190,000.

Calculate the amount of cash that would be available to the owners if tl accounts receivable are collected, the other assets are sold as describe and the liabilities are paid off in full.

2-10.   Calculate cash available upon liquidation of business.

Kimber Co. is in the process of liquidating and going out of business. The firm's accountant has provided the following balance sheet and additional information:

Assets

Cash................................................... $ 18,400

Accounts receivable............................. 62,600

Merchandise inventory....................... 114,700

Total current assets............................................ $195,700

Land...................................................    $ 51,000

Buildings & equipment......................... 343,000

Less: Accumulated depreciation.........    (195,000)

Total land, buildings, & equipment ....                 199,000

Total assets........................................                 $394,700

Liabilities

Accounts payable............................... $ 46,700

Notes payable....................................         58,500

Total current liabilities.......................                 $105,200

Long-term debt..................................................... 64,800

Owners' Equity

Common stock, no par                       $110,000

Retained earnings                                      114,700

Total owner's equity                                           $224,700

Total liabilities and owners' equity                     $394,700

It is estimated that the Merchandise Inventory can be disposed of in a liquidation sale for 85 percent of its cost, and all but 12 percent of the

Required: Accounts Receivable can be collected. Buildings & Equipment can be sold at $40,000 above book value (the difference between original cost and accumulated depreciation shown on the balance sheet), and the land can be sold at its current appraisal value of $65,000. In addition to the liabilities included in the balance sheet, $2,400 is owed to employees for their work since the last pay period, and interest of $5,250 has accrued on notes payable and long-term debt.

a.   Calculate the amount of cash that would be available to the stockholders
if the accounts receivable are collected, the other assets are sold as
described, and all liabilities and other claims are paid in full.

b.   Briefly explain why the amount of cash available to stockholders (com­
putted in part a is different than the amount of total owner's equity
shown in the balance sheet.

2-11.    Understanding and analyzing financial statement relationships.

Pope's Garage had the following accounts and amounts in its financial statements on December 31, 1996. Assume that all balance sheet items reflect account balances at December 31, 1996, and that all income state­ment items reflect activities that occurred during the year then ended.

Accounts receivable.......................................... $33,000

Depreciation expense........................................ 12,000

Land.................................................................. 27,000

Retained earnings.............................................. 59,000

Cash.................................................................... 9,000

Equipment........................................................ 71,000

Supplies............................................................   6,000

Accounts payable.............................................. 23,000

Service revenue................................................. 70,000

Interest expense................................................   4,000

Common stock.................................................. 10,000

Income tax expense........................................... 12,000

Accumulated depreciation................................. 45,000

Long-term debt................................................. 40,000

Supplies expense............................................... 14,000

Merchandise inventory..................................... 31,000

a.   Calculate the total current assets at December 31, 1996.

b.   Calculate the total liabilities and owners' equity at December 31, 1996.
с Calculate the earnings from operations (operating income) for the year

ended December 31, 1996.

d.   Calculate the net income (or loss) for the year ended December 31,
1996.

e.   What was the average income tax rate for Pope's Garage for 1996?
/ If $16,000 of dividends had been declared and paid during the year,

what was the January 1, 1996, balance of retained earnings?

Required:  2-12.    Understanding and analyzing financial statement relationships.

Gary's TV had the following accounts and amounts in its financial state­ments on December 31, 1996. Assume that all balance sheet items reflect account balances at December 31, 1996, and that all income statement items reflect activities that occurred during the year then ended.

Interest expense............................................... $    9,000

Paid-in capital.................................................. 20,000

Accumulated depreciation................................    6,000

Notes payable (long term)................................ 72,000

Rent expense.................................................... 18,000

Merchandise inventory..................................... 210,000

Accounts receivable.......................................... 48,000

Depreciation expense.......................................... 3,000

Land.................................................................. 32,000

Retained earnings............................................. 225,000

Cash................................................................. 36,000

Cost of goods sold........................................... 440,000

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

Income tax expense.......................................... 60,000

Accounts payable............................................ 23,000

Sales revenue................................................... 620,000

a.   Calculate the difference between current assets and current liabilities
for Gary's TV at December 31, 1996.

b.   Calculate the total assets at December 31, 1996.

с Calculate the earnings from operations (operating income) for the year ended December 31, 1996.

d.   Calculate the net income (or loss) for the year ended December 31,
1996.

e.   What was the average income tax rate for Gary's TV for 1996?

/ If $64,000 of dividends had been declared and paid during the year, what was the January 1, 1996, balance of retained earnings?

2-13.    Prepare an income statement, balance sheet, and

statement of changes in owners' equity; analyze results.

The following information was obtained from the records of Breanne, Inc.:

Accounts receivable......................................... $ 10,000

Accumulated depreciation................................ 52,000

Cost of goods sold........................................... 128,000

Income tax expense............................................ 8,000

Cash................................................................ 65,000

Sales................................................................ 200,000

Equipment....................................................... 120,000

Required:

Selling, general, and administrative expenses     $ 34,000

Common stock (9,000 shares)..................... 90,000

Accounts payable......................................... 15,000

Retained earnings, 1/1/96............................. 23,000

Interest expense..........................................    6,000

Merchandise inventory............................... 37,000

Long-term debt........................................... 40,000

Dividends declared and paid during 1996.. 12,000

Except as otherwise indicated, assume that all balance sheet items reflect account balances at December 31, 1996, and that all income statement items reflect activities that occurred during the year ended December 31, 1996. There were no changes in paid-in capital during the year.

a.   Prepare an income statement and statement of changes in owners'
equity for the year ended December 31, 1996, and a balance sheet at
December 31,1996, for Breanne, Inc. Based on the financial statements
that you have prepared for part a, answer the questions in parts b-e
below. Provide brief explanations for each of your answers, and state
any assumptions you believe are necessary to ensure that your answers
are correct.

b.   What is the company's average income tax rate?
с What interest rate is charged on long-term debt?

d.   What is the par value per share of common stock?

e.   What is the company's dividend policy (i.e., what proportion of the
company's earnings are used for dividends)?

1.   Prepare an income statement, balance sheet, and

statement of changes in owners' equity; analyze results.

The following information was obtained from the records of Shae, Inc.:

Merchandise inventory............................... $ 44,000

Notes payable (long term)............................ 50,000

Sales........................................................... 150,000

Buildings and equipment............................   84,000

Selling, general, and administrative expenses              12,000

Accounts receivable....................................   20,000

Common stock (7,000 shares)....................   35,000

Income tax expense....................................   14,000

Cash...........................................................   32,000

Retained earnings, 1/1/96...........................   21,500

Accrued liabilities.......................................     3,000

Cost of goods sold.....................................   90,000

Accumulated depreciation..........................   36,000

Interest expense............................................. 8,000

Accounts payable.......................................   15,000

Dividends declared and paid during 1996...... 6,500