SPECIMEN FINANCIAL STATEMENTS: PepsiCo, Inc.€¦ · PepsiCo International PepsiCo Beverages North...

THE ANNUAL REPORT

SPECIMEN FINANCIAL STATEMENTS:

PepsiCo, Inc.

Appendix A

The financial information herein is reprinted with permission from the PepsiCo, Inc. 2005 AnnualReport. The complete financial statements are available through a link at the book’s companionwebsite.

Once each year a corporation communicates to its stockholders and other interestedparties by issuing a complete set of audited financial statements.The annual report, asthis communication is called, summarizes the financial results of the company’s oper-ations for the year and its plans for the future.Many annual reports are attractive,mul-ticolored, glossy public relations pieces, containing pictures of corporate officers anddirectors as well as photos and descriptions of new products and new buildings. Yetthe basic function of every annual report is to report financial information, almost allof which is a product of the corporation’s accounting system.

The content and organization of corporate annual reports have become fairlystandardized. Excluding the public relations part of the report (pictures, products,etc.), the following are the traditional financial portions of the annual report:

FINANCIAL HIGHLIGHTSCompanies usually present the financial highlights section inside the front cover ofthe annual report or on its first two pages. This section generally reports the totalor per share amounts for five to ten financial items for the current year and one ormore previous years. Financial items from the income statement and the balancesheet that typically are presented are sales, income from continuing operations, netincome, net income per share, net cash provided by operating activities, dividendsper common share, and the amount of capital expenditures.The financial highlightssection from PepsiCo’s Annual Report is shown on page A-2.

A1

• Financial Highlights• Letter to the Stockholders• Management’s Discussion and

Analysis• Financial Statements• Notes to the Financial Statements

• Management’s Report on InternalControl

• Management Certification ofFinancial Statements

• Auditor’s Report• Supplementary Financial Information

In this appendix we illustrate current financial reporting with a comprehensiveset of corporate financial statements that are prepared in accordance with gener-ally accepted accounting principles and audited by an international independentcertified public accounting firm.We are grateful for permission to use the actual fi-nancial statements and other accompanying financial information from the annualreport of a large, publicly held company, PepsiCo, Inc.

LETTER TO THE STOCKHOLDERS

A2 Appendix A Specimen Financial Statements: PepsiCo, Inc.

Nearly every annual report contains a letter to the stockholders from the chairmanof the board or the president, or both. This letter typically discusses the company’saccomplishments during the past year and highlights significant events such asmergers and acquisitions, new products, operating achievements, business philoso-phy, changes in officers or directors, financing commitments, expansion plans, and

2005 2004 % Chg(a)

Summary of Operations

Total net revenue $32,562 $29,261 11

Division operating profit $6,710 $6,098 10

Total operating profit $5,922 $5,259 13

Net income(b) $4,536 $4,004 13

Earnings per share(b) $2.66 $2.32 15

Other Data

Management operating cash flow(c) $4,204 $3,705 13

Net cash provided by

operating activities $5,852 $5,054 16

Capital spending $1,736 $1,387 25

Common share repurchases $3,012 $3,028 (0.5)

Dividends paid $1,642 $1,329 24

Long-term debt $2,313 $2,397 (3.5)

(a) Percentage changes above and in text are based on unrounded amounts.

(b) In 2005, excludes the impact of AJCA tax charge, the 53rd week and restructuring charges.In 2004, excludes certain prior year tax benefits, and restructuring and impairment charges.See page 76 for reconciliation to net income and earnings per share on a GAAP basis.

(c) Includes the impact of net capital spending. Also, see “Our Liquidity, Capital Resourcesand Financial Position” in Management’s Discussion and Analysis.

PepsiCo International

PepsiCo Beverages North America

Frito-Lay North America

Quaker Foods North America35%5%

32%28%

24%

38%

8%

30%

PepsiCo International

PepsiCo Beverages North America

Frito-Lay North America

Quaker Foods North America

Division Operating ProfitTotal: $6,710

Net RevenueTotal: $32,562

Financial HighlightsPepsiCo, Inc. and Subsidiaries($ in millions except per share amounts; all per share amounts assume dilution)

Financial Statements and Accompanying Notes A3

MANAGEMENT’S DISCUSSION AND ANALYSISThe management’s discussion and analysis (MD&A) section covers three financialaspects of a company: its results of operations, its ability to pay near-term obliga-tions, and its ability to fund operations and expansion. Management must highlightfavorable or unfavorable trends and identity significant events and uncertaintiesthat affect these three factors. This discussion obviously involves a number of sub-jective estimates and opinions. In its MD&A section, PepsiCo breaks its discussioninto three major headings: Our Business, Our Critical Accounting Policies, and OurFinancial Results. PepsiCo’s MD&A section is 22 pages long. You can access thatsection at www.wiley.com/college/weygandt.

future prospects. The letter to the stockholders is signed by Steve Reinemund,Chairman of the Board and Chief Executive Officer, of PepsiCo.

Only a short summary of the letter is provided below. The full letter can beaccessed at the book’s companion website at www.wiley.com/college/weygandt.

FINANCIAL STATEMENTS AND ACCOMPANYING NOTES

The standard set of financial statements consists of: (1) a comparative incomestatement for 3 years, (2) a comparative statement of cash flows for 3 years, (3) acomparative balance sheet for 2 years, (4) a statement of stockholders’ equity for3 years, and (5) a set of accompanying notes that are considered an integral partof the financial statements. The auditor’s report, unless stated otherwise, coversthe financial statements and the accompanying notes. PepsiCo’s financial state-ments and accompanying notes plus supplementary data and analyses follow.

Consolidated Statement of IncomePepsiCo, Inc. and SubsidiariesFiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions except per share amounts) 2005 2004 2003

Net Revenue........................................................................................................................... $32,562 $29,261 $26,971

Cost of sales........................................................................................................................... 14,176 12,674 11,691Selling, general and administrative expenses ........................................................................ 12,314 11,031 10,148Amortization of intangible assets ........................................................................................... 150 147 145Restructuring and impairment charges.................................................................................. – 150 147Merger-related costs............................................................................................................... – – 59

Operating Profit ..................................................................................................................... 5,922 5,259 4,781

Bottling equity income............................................................................................................ 557 380 323Interest expense...................................................................................................................... (256) (167) (163)Interest income....................................................................................................................... 159 74 51

Income from Continuing Operations before Income Taxes ................................................. 6,382 5,546 4,992

Provision for Income Taxes................................................................................................... 2,304 1,372 1,424

Income from Continuing Operations..................................................................................... 4,078 4,174 3,568

Tax Benefit from Discontinued Operations ........................................................................... – 38 –

Net Income ............................................................................................................................ $ 4,078 $ 4,212 $ 3,568

Net Income per Common Share — BasicContinuing operations ....................................................................................................... $2.43 $2.45 $2.07Discontinued operations.................................................................................................... – 0.02 –

Total .................................................................................................................................. $2.43 $2.47 $2.07

Net Income per Common Share — DilutedContinuing operations ....................................................................................................... $2.39 $2.41 $2.05Discontinued operations.................................................................................................... – 0.02 –

Total .................................................................................................................................. $2.39 $2.44* $2.05

* Based on unrounded amounts.See accompanying notes to consolidated financial statements.

2003 2004 2005

2003 2004 2005 2003 2004 2005

2003 2004 2005

$2.05

$2.41

$32,562

$26,971$29,261

$5,922

$4,781$5,259

$3,568

$4,174 $4,078

$2.39

Net Revenue Operating Profit

Net Income per Common Share — Continuing OperationsIncome from Continuing Operations


Consolidated Statement of Cash FlowsPepsiCo, Inc. and SubsidiariesFiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions) 2005 2004 2003Operating ActivitiesNet income................................................................................................................................. $ 4,078 $ 4,212 $ 3,568Adjustments to reconcile net income to net cash provided by operating activities

Depreciation and amortization ............................................................................................. 1,308 1,264 1,221Stock-based compensation expense..................................................................................... 311 368 407Restructuring and impairment charges ............................................................................... – 150 147Cash payments for merger-related costs and restructuring charges ................................... (22) (92) (109)Tax benefit from discontinued operations............................................................................. – (38) –Pension and retiree medical plan contributions ................................................................... (877) (534) (605)Pension and retiree medical plan expenses.......................................................................... 464 395 277Bottling equity income, net of dividends .............................................................................. (411) (297) (276)Deferred income taxes and other tax charges and credits ................................................... 440 (203) (286)Merger-related costs............................................................................................................. – – 59Other non-cash charges and credits, net ............................................................................. 145 166 101Changes in operating working capital, excluding effects of acquisitions and divestitures

Accounts and notes receivable........................................................................................ (272) (130) (220)Inventories ...................................................................................................................... (132) (100) (49)Prepaid expenses and other current assets .................................................................... (56) (31) 23Accounts payable and other current liabilities................................................................ 188 216 (11)Income taxes payable...................................................................................................... 609 (268) 182

Net change in operating working capital.............................................................................. 337 (313) (75)Other..................................................................................................................................... 79 (24) (101)

Net Cash Provided by Operating Activities .............................................................................. 5,852 5,054 4,328

Investing ActivitiesSnack Ventures Europe (SVE) minority interest acquisition ....................................................... (750) – –Capital spending ....................................................................................................................... (1,736) (1,387) (1,345)Sales of property, plant and equipment..................................................................................... 88 38 49Other acquisitions and investments in noncontrolled affiliates ................................................ (345) (64) (71)Cash proceeds from sale of PBG stock ...................................................................................... 214 – –Divestitures................................................................................................................................ 3 52 46Short-term investments, by original maturity

More than three months — purchases ................................................................................ (83) (44) (38)More than three months — maturities ................................................................................ 84 38 28Three months or less, net ..................................................................................................... (992) (963) (940)

Net Cash Used for Investing Activities..................................................................................... (3,517) (2,330) (2,271)

Financing ActivitiesProceeds from issuances of long-term debt .............................................................................. 25 504 52Payments of long-term debt ...................................................................................................... (177) (512) (641)Short-term borrowings, by original maturity

More than three months — proceeds................................................................................... 332 153 88More than three months — payments ................................................................................. (85) (160) (115)Three months or less, net ..................................................................................................... 1,601 1,119 40

Cash dividends paid .................................................................................................................. (1,642) (1,329) (1,070)Share repurchases — common ................................................................................................. (3,012) (3,028) (1,929)Share repurchases — preferred ................................................................................................ (19) (27) (16)Proceeds from exercises of stock options................................................................................... 1,099 965 689

Net Cash Used for Financing Activities.................................................................................... (1,878) (2,315) (2,902)

Effect of exchange rate changes on cash and cash equivalents ............................................... (21) 51 27

Net Increase/(Decrease) in Cash and Cash Equivalents ......................................................... 436 460 (818)Cash and Cash Equivalents, Beginning of Year ....................................................................... 1,280 820 1,638

Cash and Cash Equivalents, End of Year ................................................................................. $ 1,716 $ 1,280 $ 820

See accompanying notes to consolidated financial statements.



Consolidated Balance SheetPepsiCo, Inc. and SubsidiariesDecember 31, 2005 and December 25, 2004

(in millions except per share amounts) 2005 2004

ASSETS

Current Assets

Cash and cash equivalents................................................................................................................................... $ 1,716 $ 1,280

Short-term investments ........................................................................................................................................ 3,166 2,165

4,882 3,445Accounts and notes receivable, net....................................................................................................................... 3,261 2,999

Inventories............................................................................................................................................................. 1,693 1,541

Prepaid expenses and other current assets........................................................................................................... 618 654

Total Current Assets ....................................................................................................................................... 10,454 8,639

Property, Plant and Equipment, net .................................................................................................................... 8,681 8,149

Amortizable Intangible Assets, net ...................................................................................................................... 530 598

Goodwill................................................................................................................................................................. 4,088 3,909

Other nonamortizable intangible assets................................................................................................................ 1,086 933

Nonamortizable Intangible Assets.................................................................................................................. 5,174 4,842

Investments in Noncontrolled Affiliates .............................................................................................................. 3,485 3,284

Other Assets ......................................................................................................................................................... 3,403 2,475

Total Assets................................................................................................................................................ $31,727 $27,987

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current Liabilities

Short-term obligations .......................................................................................................................................... $ 2,889 $ 1,054

Accounts payable and other current liabilities...................................................................................................... 5,971 5,599

Income taxes payable ............................................................................................................................................ 546 99

Total Current Liabilities .................................................................................................................................. 9,406 6,752

Long-Term Debt Obligations................................................................................................................................. 2,313 2,397

Other Liabilities .................................................................................................................................................... 4,323 4,099

Deferred Income Taxes ........................................................................................................................................ 1,434 1,216

Total Liabilities................................................................................................................................................ 17,476 14,464Commitments and Contingencies

Preferred Stock, no par value ............................................................................................................................. 41 41

Repurchased Preferred Stock ............................................................................................................................. (110) (90)

Common Shareholders’ Equity

Common stock, par value 1 2/3¢ per share (issued 1,782 shares)....................................................................... 30 30

Capital in excess of par value............................................................................................................................... 614 618Retained earnings ................................................................................................................................................. 21,116 18,730Accumulated other comprehensive loss ................................................................................................................ (1,053) (886)

20,707 18,492

Less: repurchased common stock, at cost (126 and 103 shares, respectively) ................................................... (6,387) (4,920)

Total Common Shareholders’ Equity .............................................................................................................. 14,320 13,572

Total Liabilities and Shareholders’ Equity ................................................................................................ $31,727 $27,987

See accompanying notes to consolidated financial statements.


Consolidated Statement of Common Shareholders’ EquityPepsiCo, Inc. and SubsidiariesFiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

(in millions) 2005 2004 2003Shares Amount Shares Amount Shares Amount

Common Stock 1,782 $ 30 1,782 $ 30 1,782 $ 30

Capital in Excess of Par ValueBalance, beginning of year........................................... 618 548 207Stock-based compensation expense............................. 311 368 407Stock option exercises(a) ............................................... (315) (298) (66)

Balance, end of year..................................................... 614 618 548

Retained EarningsBalance, beginning of year........................................... 18,730 15,961 13,489Net income ................................................................... 4,078 4,212 3,568Cash dividends declared — common .......................... (1,684) (1,438) (1,082)Cash dividends declared — preferred ......................... (3) (3) (3)Cash dividends declared — RSUs ............................... (5) (2) –Other ............................................................................ – – (11)

Balance, end of year..................................................... 21,116 18,730 15,961

Accumulated Other Comprehensive LossBalance, beginning of year .......................................... (886) (1,267) (1,672)Currency translation adjustment.................................. (251) 401 410Cash flow hedges, net of tax:

Net derivative gains/(losses) .................................. 54 (16) (11)Reclassification of (gains)/losses to net income .... (8) 9 (1)

Minimum pension liability adjustment,net of tax ............................................................... 16 (19) 7

Unrealized gain on securities, net of tax ...................... 24 6 1Other ............................................................................ (2) – (1)

Balance, end of year..................................................... (1,053) (886) (1,267)

Repurchased Common StockBalance, beginning of year........................................... (103) (4,920) (77) (3,376) (60) (2,524)Share repurchases........................................................ (54) (2,995) (58) (2,994) (43) (1,946)Stock option exercises .................................................. 31 1,523 32 1,434 26 1,096Other ............................................................................ – 5 – 16 – (2)

Balance, end of year..................................................... (126) (6,387) (103) (4,920) (77) (3,376)

Total Common Shareholders’ Equity ................................ $14,320 $13,572 $11,896

2005 2004 2003Comprehensive Income

Net income .................................................................. $4,078 $4,212 $3,568Currency translation adjustment.................................. (251) 401 410Cash flow hedges, net of tax ........................................ 46 (7) (12)Minimum pension liability adjustment, net of tax ....... 16 (19) 7Unrealized gain on securities, net of tax ...................... 24 6 1Other ............................................................................ (2) – (1)

Total Comprehensive Income........................................... $3,911 $4,593 $3,973

(a) Includes total tax benefit of $125 million in 2005, $183 million in 2004 and $340 million in 2003.See accompanying notes to consolidated financial statements.


Our financial statements include the con-solidated accounts of PepsiCo, Inc. andthe affiliates that we control. In addition,we include our share of the results of cer-tain other affiliates based on our economicownership interest. We do not control theseother affiliates, as our ownership in theseother affiliates is generally less than 50%.Our share of the net income of noncon-trolled bottling affiliates is reported in ourincome statement as bottling equityincome. Bottling equity income alsoincludes any changes in our ownershipinterests of these affiliates. In 2005, bot-tling equity income includes $126 millionof pre-tax gains on our sales of PBG stock.See Note 8 for additional information onour noncontrolled bottling affiliates. Ourshare of other noncontrolled affiliates isincluded in division operating profit.Intercompany balances and transactionsare eliminated. In 2005, we had an addi-tional week of results (53rd week). Ourfiscal year ends on the last Saturday ofeach December, resulting in an additionalweek of results every five or six years.

In connection with our ongoing BPTinitiative, we aligned certain accountingpolicies across our divisions in 2005. Weconformed our methodology for calculatingour bad debt reserves and modified ourpolicy for recognizing revenue for productsshipped to customers by third-partycarriers. Additionally, we conformed ourmethod of accounting for certain costs,primarily warehouse and freight. Thesechanges reduced our net revenue by$36 million and our operating profit by$60 million in 2005. We also made certainreclassifications on our ConsolidatedStatement of Income in the fourth quarterof 2005 from cost of sales to selling,general and administrative expenses inconnection with our BPT initiative. Thesereclassifications resulted in reductions tocost of sales of $556 million through thethird quarter of 2005, $732 million in thefull year 2004 and $688 million in the fullyear 2003, with corresponding increases toselling, general and administrativeexpenses in those periods. These reclassifi-cations had no net impact on operatingprofit and have been made to all periodspresented for comparability.

The preparation of our consolidatedfinancial statements in conformity withgenerally accepted accounting principlesrequires us to make estimates andassumptions that affect reported amountsof assets, liabilities, revenues, expensesand disclosure of contingent assets andliabilities. Estimates are used in determin-ing, among other items, sales incentivesaccruals, future cash flows associated withimpairment testing for perpetual brandsand goodwill, useful lives for intangibleassets, tax reserves, stock-based compen-sation and pension and retiree medicalaccruals. Actual results could differ fromthese estimates.

See “Our Divisions” below and foradditional unaudited information on itemsaffecting the comparability of ourconsolidated results, see “Items AffectingComparability” in Management’sDiscussion and Analysis.

Tabular dollars are in millions, except pershare amounts. All per share amountsreflect common per share amounts, assumedilution unless noted, and are based onunrounded amounts. Certain reclassifica-tions were made to prior years’ amounts toconform to the 2005 presentation.

We manufacture or use contract manufac-turers, market and sell a variety of salty,sweet and grain-based snacks, carbonatedand non-carbonated beverages, and foodsthrough our North American and interna-tional business divisions. Our NorthAmerican divisions include the UnitedStates and Canada. The accounting poli-cies for the divisions are the same as thosedescribed in Note 2, except for certainallocation methodologies for stock-basedcompensation expense and pension andretiree medical expense, as described inthe unaudited information in “Our CriticalAccounting Policies.” Additionally, begin-

ning in the fourth quarter of 2005, webegan centrally managing commodityderivatives on behalf of our divisions.Certain of the commodity derivatives,primarily those related to the purchase ofenergy for use by our divisions, do notqualify for hedge accounting treatment.These derivatives hedge underlying com-modity price risk and were not entered intofor speculative purposes. Such derivativesare marked to market with the resultinggains and losses recognized as a compo-nent of corporate unallocated expense.These gains and losses are reflected indivision results when the divisions take

delivery of the underlying commodity.Therefore, division results reflect thecontract purchase price of the energy orother commodities.

Division results are based on how ourChairman and Chief Executive Officerevaluates our divisions. Division resultsexclude certain Corporate-initiated restruc-turing and impairment charges, merger-related costs and divested businesses.For additional unaudited information onour divisions, see “Our Operations” inManagement’s Discussion and Analysis.

Notes to Consolidated Financial StatementsNote 1 — Basis of Presentation and Our Divisions

Our Divisions

Basis of Presentation


2005 2004 2003 2005 2004 2003Net Revenue Operating Profit

FLNA...................................................................... $10,322 $ 9,560 $ 9,091 $2,529 $2,389 $2,242PBNA..................................................................... 9,146 8,313 7,733 2,037 1,911 1,690PI ......................................................................... 11,376 9,862 8,678 1,607 1,323 1,061QFNA ..................................................................... 1,718 1,526 1,467 537 475 470Total division ........................................................ 32,562 29,261 26,969 6,710 6,098 5,463Divested businesses ............................................. – – 2 – – 26Corporate .............................................................. – – – (788) (689) (502)

32,562 29,261 26,971 5,922 5,409 4,987Restructuring and impairment charges................ – – – – (150) (147)Merger-related costs ............................................. – – – – – (59)Total...................................................................... $32,562 $29,261 $26,971 $5,922 $5,259 $4,781

Divested BusinessesDuring 2003, we sold our Quaker FoodsNorth America Mission pasta business. Theresults of this business are reported asdivested businesses.

CorporateCorporate includes costs of our corporateheadquarters, centrally managed initia-tives, such as our BPT initiative, unallo-cated insurance and benefit programs,foreign exchange transaction gains andlosses, and certain commodity derivative

gains and losses, as well as profit-in-inven-tory elimination adjustments for our non-controlled bottling affiliates and certainother items.

Restructuring and Impairment Charges andMerger-Related Costs — See Note 3.

QFNA5%

FLNA32%

PBNA28%

PI35%

Division Net Revenue

QFNA8%

FLNA38%

PBNA30%

PI24%

Division Operating Profit

Frito-LayNorth America

(FLNA)

Quaker FoodsNorth America

(QFNA)

PepsiCoBeverages

North America(PBNA)

PepsiCoInternational

(PI)


Other Division Information2005 2004 2003 2005 2004 2003

Total Assets Capital SpendingFLNA $ 5,948 $ 5,476 $ 5,332 $ 512 $ 469 $ 426PBNA 6,316 6,048 5,856 320 265 332PI 9,983 8,921 8,109 667 537 521QFNA 989 978 995 31 33 32Total division 23,236 21,423 20,292 1,530 1,304 1,311Corporate(a) 5,331 3,569 2,384 206 83 34Investments in bottling affiliates 3,160 2,995 2,651 – – –

$31,727 $27,987 $25,327 $1,736 $1,387 $1,345

(a) Corporate assets consist principally of cash and cash equivalents, short-term investments, and property, plant and equipment.

2005 2004 2003 2005 2004 2003Amortization of Depreciation and

Intangible Assets Other AmortizationFLNA $ 3 $ 3 $ 3 $ 419 $ 420 $ 416PBNA 76 75 75 264 258 245PI 71 68 66 420 382 350QFNA – 1 1 34 36 36Total division 150 147 145 1,137 1,096 1,047Corporate – – – 21 21 29

$150 $147 $145 $1,158 $1,117 $1,076

2005 2004 2003 2005 2004 2003Net Revenue(a) Long-Lived Assets(b)

U.S. $19,937 $18,329 $17,377 $10,723 $10,212 $ 9,907Mexico 3,095 2,724 2,642 902 878 869United Kingdom 1,821 1,692 1,510 1,715 1,896 1,724Canada 1,509 1,309 1,147 582 548 508All other countries 6,200 5,207 4,295 3,948 3,339 3,123

$32,562 $29,261 $26,971 $17,870 $16,873 $16,131

(a) Represents net revenue from businesses operating in these countries.

(b) Long-lived assets represent net property, plant and equipment, nonamortizable and net amortizable intangible assets and investments innoncontrolled affiliates. These assets are reported in the country where they are primarily used.

FLNA19%

PBNA20%

PI31%

QFNA3%

Other27%

Total AssetsQFNA2%

FLNA30%

PBNA18%

PI38%

Other12%

Capital Spending

Canada4%

United States61%

Mexico10%

UnitedKingdom6%

Other19%

Net Revenue

Canada3%

United States60%

Mexico5%

UnitedKingdom10%

Other22%

Long-Lived Assets


Revenue RecognitionWe recognize revenue upon shipment ordelivery to our customers based on writtensales terms that do not allow for a right ofreturn. However, our policy for direct-store-delivery (DSD) and chilled products is toremove and replace damaged and out-of-date products from store shelves to ensurethat our consumers receive the productquality and freshness that they expect.Similarly, our policy for warehouse distrib-uted products is to replace damaged andout-of-date products. Based on our histori-cal experience with this practice, we havereserved for anticipated damaged and out-of-date products. For additional unauditedinformation on our revenue recognition andrelated policies, including our policy onbad debts, see “Our Critical AccountingPolicies” in Management’s Discussion andAnalysis. We are exposed to concentrationof credit risk by our customers, Wal-Martand PBG. Wal-Mart represents approxi-mately 9% of our net revenue, includingconcentrate sales to our bottlers which areused in finished goods sold by them toWal-Mart; and PBG represents approxi-mately 10%. We have not experiencedcredit issues with these customers.

Sales Incentives and Other MarketplaceSpendingWe offer sales incentives and discountsthrough various programs to our customersand consumers. Sales incentives and dis-counts are accounted for as a reduction ofrevenue and totaled $8.9 billion in 2005,$7.8 billion in 2004 and $7.1 billion in2003. While most of these incentivearrangements have terms of no more thanone year, certain arrangements extendbeyond one year. For example, fountainpouring rights may extend up to 15 years.Costs incurred to obtain these arrange-ments are recognized over the contractperiod and the remaining balances of$321 million at December 31, 2005 and$337 million at December 25, 2004 areincluded in current assets and other assetsin our Consolidated Balance Sheet. Foradditional unaudited information on our

sales incentives, see “Our CriticalAccounting Policies” in Management’sDiscussion and Analysis.

Other marketplace spending includes thecosts of advertising and other marketingactivities and is reported as selling, generaland administrative expenses. Advertisingexpenses were $1.8 billion in 2005,$1.7 billion in 2004 and $1.6 billion in2003. Deferred advertising costs are notexpensed until the year first used andconsist of:• media and personal service prepayments,• promotional materials in inventory, and• production costs of future media

advertising.Deferred advertising costs of $202 mil-

lion and $137 million at year-end 2005and 2004, respectively, are classified asprepaid expenses in our ConsolidatedBalance Sheet.

Distribution CostsDistribution costs, including the costs ofshipping and handling activities, arereported as selling, general and administra-tive expenses. Shipping and handlingexpenses were $4.1 billion in 2005,$3.9 billion in 2004 and $3.6 billionin 2003.

Cash EquivalentsCash equivalents are investments withoriginal maturities of three months or lesswhich we do not intend to rollover beyondthree months.

Software CostsWe capitalize certain computer softwareand software development costs incurredin connection with developing or obtainingcomputer software for internal use.Capitalized software costs are included inproperty, plant and equipment on ourConsolidated Balance Sheet and amortizedon a straight-line basis over the estimateduseful lives of the software, which gener-ally do not exceed 5 years. Net capitalizedsoftware and development costs were$327 million at December 31, 2005 and$181 million at December 25, 2004.

Commitments and ContingenciesWe are subject to various claims andcontingencies related to lawsuits, taxesand environmental matters, as well ascommitments under contractual and othercommercial obligations. We recognize lia-bilities for contingencies and commitmentswhen a loss is probable and estimable. Foradditional information on our commit-ments, see Note 9.

Other Significant Accounting PoliciesOur other significant accounting policiesare disclosed as follows:• Property, Plant and Equipment and

Intangible Assets — Note 4 and, foradditional unaudited information onbrands and goodwill, see “Our CriticalAccounting Policies” in Management’sDiscussion and Analysis.

• Income Taxes — Note 5 and, for addi-tional unaudited information, see “OurCritical Accounting Policies” inManagement’s Discussion and Analysis.

• Stock-Based Compensation Expense —Note 6 and, for additional unauditedinformation, see “Our CriticalAccounting Policies” in Management’sDiscussion and Analysis.

• Pension, Retiree Medical and SavingsPlans — Note 7 and, for additionalunaudited information, see “Our CriticalAccounting Policies” in Management’sDiscussion and Analysis.

• Risk Management — Note 10 and, foradditional unaudited information, see“Our Business Risks” in Management’sDiscussion and Analysis.There have been no new accounting

pronouncements issued or effective during2005 that have had, or are expected tohave, a material impact on our consoli-dated financial statements.

Note 2 — Our Significant Accounting Policies


2005 Restructuring ChargesIn the fourth quarter of 2005, we incurreda charge of $83 million ($55 million after-tax or $0.03 per share) in conjunction withactions taken to reduce costs in our opera-tions, principally through headcount reduc-tions. Of this charge, $34 million relatedto FLNA, $21 million to PBNA, $16million to PI and $12 million to Corporate(recorded in corporate unallocatedexpenses). Most of this charge related tothe termination of approximately 700employees. We expect the substantialportion of the cash payments related tothis charge to be paid in 2006.

2004 and 2003 Restructuring andImpairment ChargesIn the fourth quarter of 2004, we incurreda charge of $150 million ($96 millionafter-tax or $0.06 per share) in conjunc-tion with the consolidation of FLNA’smanufacturing network as part of its ongo-ing productivity program. Of this charge,

$93 million related to asset impairment,primarily reflecting the closure of four U.S.plants. Production from these plants wasredeployed to other FLNA facilities in theU.S. The remaining $57 million includedemployee-related costs of $29 million,contract termination costs of $8 millionand other exit costs of $20 million.Employee-related costs primarily reflectthe termination costs for approximately700 employees. Through December 31,2005, we have paid $47 million andincurred non-cash charges of $10 million,leaving substantially no accrual.

In the fourth quarter of 2003, weincurred a charge of $147 million($100 million after-tax or $0.06 per share)in conjunction with actions taken tostreamline our North American divisionsand PepsiCo International. These actionswere taken to increase focus and eliminateredundancies at PBNA and PI and toimprove the efficiency of the supply chain

at FLNA. Of this charge, $81 millionrelated to asset impairment, reflecting$57 million for the closure of a snackplant in Kentucky, the retirement of snackmanufacturing lines in Maryland andArkansas and $24 million for the closureof a PBNA office building in Florida. Theremaining $66 million included employee-related costs of $54 million and facilityand other exit costs of $12 million.Employee-related costs primarily reflectthe termination costs for approximately850 sales, distribution, manufacturing,research and marketing employees. As ofDecember 31, 2005, all terminations hadoccurred and substantially no accrualremains.

Merger-Related CostsIn connection with the Quaker merger in2001, we recognized merger-related costsof $59 million ($42 million after-tax or$0.02 per share) in 2003.

Depreciation and amortization arerecognized on a straight-line basis over anasset’s estimated useful life. Land is notdepreciated and construction in progress isnot depreciated until ready for service.Amortization of intangible assets for eachof the next five years, based on average2005 foreign exchange rates, is expectedto be $152 million in 2006, $35 millionin 2007, $35 million in 2008, $34 mil-lion in 2009 and $33 million in 2010.

Depreciable and amortizable assets areonly evaluated for impairment upon asignificant change in the operating ormacroeconomic environment. In thesecircumstances, if an evaluation of theundiscounted cash flows indicates impair-ment, the asset is written down to itsestimated fair value, which is based ondiscounted future cash flows. Useful livesare periodically evaluated to determinewhether events or circumstances haveoccurred which indicate the need for revi-sion. For additional unaudited informationon our amortizable brand policies, see“Our Critical Accounting Policies” inManagement’s Discussion and Analysis.

Note 3 — Restructuring and Impairment Charges and Merger-Related Costs

Note 4 — Property, Plant and Equipment and Intangible Assets

Average Useful Life 2005 2004 2003Property, plant and equipment, netLand and improvements 10 – 30 yrs. $ 685 $ 646Buildings and improvements 20 – 44 3,736 3,605Machinery and equipment,

including fleet and software 5 – 15 11,658 10,950Construction in progress 1,066 729

17,145 15,930Accumulated depreciation (8,464) (7,781)

$ 8,681 $ 8,149

Depreciation expense $1,103 $1,062 $1,020

Amortizable intangible assets, netBrands 5 – 40 $1,054 $1,008Other identifiable intangibles 3 – 15 257 225

1,311 1,233Accumulated amortization (781) (635)

$ 530 $ 598

Amortization expense $150 $147 $145


Nonamortizable Intangible AssetsPerpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue toexceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated forimpairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division.If the fair value of an evaluated asset is less than its book value, the asset is written down based on its discounted future cash flows tofair value. No impairment charges resulted from the required impairment evaluations. The change in the book value of nonamortizableintangible assets is as follows:

Balance, Translation Balance, Translation Balance,Beginning 2004 Acquisition and Other End of 2004 Acquisition and Other End of 2005

Frito-Lay North AmericaGoodwill $ 130 $ – $ 8 $ 138 $ – $ 7 $ 145PepsiCo Beverages North AmericaGoodwill 2,157 – 4 2,161 – 3 2,164Brands 59 – – 59 – – 59

2,216 – 4 2,220 – 3 2,223PepsiCo InternationalGoodwill 1,334 29 72 1,435 278 (109) 1,604Brands 808 – 61 869 263 (106) 1,026

2,142 29 133 2,304 541 (215) 2,630Quaker Foods North AmericaGoodwill 175 – – 175 – – 175CorporatePension intangible 2 – 3 5 – (4) 1Total goodwill 3,796 29 84 3,909 278 (99) 4,088Total brands 867 – 61 928 263 (106) 1,085Total pension intangible 2 – 3 5 – (4) 1

$4,665 $29 $148 $ 4,842 $541 $(209) $5,174


Note 5 — Income Taxes

2005 2004 2003Income before income taxes — continuing operationsU.S. ................................................................................................................................................... $3,175 $2,946 $3,267Foreign.............................................................................................................................................. 3,207 2,600 1,725

$6,382 $5,546 $4,992

Provision for income taxes — continuing operationsCurrent: U.S. Federal....................................................................................................................... $1,638 $1,030 $1,326

Foreign .............................................................................................................................. 426 256 341State ................................................................................................................................. 118 69 80

2,182 1,355 1,747Deferred: U.S. Federal ....................................................................................................................... 137 11 (274)

Foreign .............................................................................................................................. (26) 5 (47)State ................................................................................................................................. 11 1 (2)

122 17 (323)$2,304 $1,372 $1,424

Tax rate reconciliation — continuing operationsU.S. Federal statutory tax rate .......................................................................................................... 35.0% 35.0% 35.0%State income tax, net of U.S. Federal tax benefit.............................................................................. 1.4 0.8 1.0Taxes on AJCA repatriation................................................................................................................ 7.0 – –Lower taxes on foreign results .......................................................................................................... (6.5) (5.4) (5.5)Settlement of prior years’ audit ........................................................................................................ – (4.8) (2.2)Other, net.......................................................................................................................................... (0.8) (0.9) 0.2Annual tax rate ................................................................................................................................. 36.1% 24.7% 28.5%

Deferred tax liabilitiesInvestments in noncontrolled affiliates ............................................................................................ $ 993 $ 850Property, plant and equipment ......................................................................................................... 772 857Pension benefits ............................................................................................................................... 863 669Intangible assets other than nondeductible goodwill ....................................................................... 135 153Zero coupon notes ............................................................................................................................ 35 46Other................................................................................................................................................. 169 157Gross deferred tax liabilities............................................................................................................. 2,967 2,732Deferred tax assetsNet carryforwards ............................................................................................................................. 608 666Stock-based compensation............................................................................................................... 426 402Retiree medical benefits................................................................................................................... 400 402Other employee-related benefits....................................................................................................... 342 379Other................................................................................................................................................. 520 460Gross deferred tax assets ................................................................................................................. 2,296 2,309Valuation allowances........................................................................................................................ (532) (564)Deferred tax assets, net.................................................................................................................... 1,764 1,745Net deferred tax liabilities ................................................................................................................ $1,203 $ 987

Deferred taxes included within:Prepaid expenses and other current assets.................................................................................. $231 $229Deferred income taxes .................................................................................................................. $1,434 $1,216

Analysis of valuation allowancesBalance, beginning of year............................................................................................................... $564 $438 $487

(Benefit)/provision........................................................................................................................ (28) 118 (52)Other (deductions)/additions........................................................................................................ (4) 8 3

Balance, end of year......................................................................................................................... $532 $564 $438


For additional unaudited information onour income tax policies, including ourreserves for income taxes, see “Our CriticalAccounting Policies” in Management’sDiscussion and Analysis.

Carryforwards, Credits and AllowancesOperating loss carryforwards totaling$5.1 billion at year-end 2005 are beingcarried forward in a number of foreign andstate jurisdictions where we are permittedto use tax operating losses from prior peri-ods to reduce future taxable income. Theseoperating losses will expire as follows:$0.1 billion in 2006, $4.1 billion between2007 and 2025 and $0.9 billion may becarried forward indefinitely. In addition,certain tax credits generated in prior peri-ods of approximately $39.4 million areavailable to reduce certain foreign taxliabilities through 2011. We establishvaluation allowances for our deferred taxassets when the amount of expected futuretaxable income is not likely to support theuse of the deduction or credit.

Undistributed International EarningsThe AJCA created a one-time incentive forU.S. corporations to repatriate undistrib-uted international earnings by providing an

85% dividends received deduction. Asapproved by our Board of Directors in July2005, we repatriated approximately$7.5 billion in earnings previously consid-ered indefinitely reinvested outside the U.S.in the fourth quarter of 2005. In 2005, werecorded income tax expense of $460 mil-lion associated with this repatriation. Otherthan the earnings repatriated, we intend tocontinue to reinvest earnings outside theU.S. for the foreseeable future and, there-fore, have not recognized any U.S. taxexpense on these earnings. At December31, 2005, we had approximately $7.5 bil-lion of undistributed international earnings.

ReservesA number of years may elapse before a par-ticular matter, for which we have establisheda reserve, is audited and finally resolved.The number of years with open tax auditsvaries depending on the tax jurisdiction.During 2004, we recognized $266 million oftax benefits related to the favorable resolu-tion of certain open tax issues. In addition,in 2004, we recognized a tax benefit of$38 million upon agreement with the IRS onan open issue related to our discontinuedrestaurant operations. At the end of 2003,

we entered into agreements with the IRS foropen years through 1997. These agreementsresulted in a tax benefit of $109 million inthe fourth quarter of 2003. As part of theseagreements, we also resolved the treatmentof certain other issues related to futuretax years.

The IRS has initiated their audits of ourtax returns for the years 1998 through2002. Our tax returns subsequent to 2002have not yet been examined. While it isoften difficult to predict the final outcome orthe timing of resolution of any particular taxmatter, we believe that our reserves reflectthe probable outcome of known tax contin-gencies. Settlement of any particular issuewould usually require the use of cash.Favorable resolution would be recognized asa reduction to our annual tax rate in the yearof resolution. Our tax reserves, covering allfederal, state and foreign jurisdictions, arepresented in the balance sheet within otherliabilities (see Note 14), except for anyamounts relating to items we expect to payin the coming year which are included incurrent income taxes payable. For furtherunaudited information on the impact of theresolution of open tax issues, see “OtherConsolidated Results.”

Our stock-based compensation program isa broad-based program designed to attractand retain employees while also aligningemployees’ interests with the interests ofour shareholders. Employees at all levelsparticipate in our stock-based compensa-tion program. In addition, members of ourBoard of Directors participate in our stock-based compensation program in connec-tion with their service on our Board. Stockoptions and RSUs are granted to employ-ees under the shareholder-approved 2003Long-Term Incentive Plan (LTIP), our onlyactive stock-based plan. Stock-basedcompensation expense was $311 millionin 2005, $368 million in 2004 and$407 million in 2003. Related income taxbenefits recognized in earnings were$87 million in 2005, $103 million in2004 and $114 million in 2003. At year-end 2005, 51 million shares were avail-able for future executive and SharePowergrants. For additional unaudited informa-

tion on our stock-based compensation pro-gram, see “Our Critical Accounting Policies”in Management’s Discussion and Analysis.

SharePower GrantsSharePower options are awarded under ourLTIP to all eligible employees, based onjob level or classification, and in the caseof international employees, tenure as well.All stock option grants have an exerciseprice equal to the fair market value of ourcommon stock on the day of grant andgenerally have a 10-year term with vestingafter three years.

Executive GrantsAll senior management and certain middlemanagement are eligible for executivegrants under our LTIP. All stock optiongrants have an exercise price equal to thefair market value of our common stock onthe day of grant and generally have a10-year term with vesting after three years.There have been no reductions to the exer-

cise price of previously issued awards, andany repricing of awards would requireapproval of our shareholders.

Beginning in 2004, executives who areawarded long-term incentives based ontheir performance are offered the choice ofstock options or RSUs. RSU expense isbased on the fair value of PepsiCo stock onthe date of grant and is amortized over thevesting period, generally three years. Eachrestricted stock unit can be settled in ashare of our stock after the vesting period.Executives who elect RSUs receive oneRSU for every four stock options that wouldhave otherwise been granted. Senior offi-cers do not have a choice and are granted50% stock options and 50% RSUs.Vesting of RSU awards for senior officers iscontingent upon the achievement ofpre-established performance targets. Wegranted 3 million RSUs in both 2005 and2004 with weighted-average intrinsic val-ues of $53.83 and $47.28, respectively.

Note 6 — Stock-Based Compensation


Method of Accounting and Our AssumptionsWe account for our employee stock options under the fair valuemethod of accounting using a Black-Scholes valuation model tomeasure stock-based compensation expense at the date of grant.We adopted SFAS 123R, Share-Based Payment, under themodified prospective method in the first quarter of 2006. We donot expect our adoption of SFAS 123R to materially impact ourfinancial statements.

Our weighted-average Black-Scholes fair value assumptions include:

2005 2004 2003Expected life 6 yrs. 6 yrs. 6 yrs.Risk free interest rate 3.8% 3.3% 3.1%Expected volatility 23% 26% 27%Expected dividend yield 1.8% 1.8% 1.15%

Our Stock Option Activity(a)

2005 2004 2003Options Average Price(b) Options Average Price(b) Options Average Price(b)

Outstanding at beginning of year 174,261 $40.05 198,173 $38.12 190,432 $36.45Granted 12,328 53.82 14,137 47.47 41,630 39.89Exercised (30,945) 35.40 (31,614) 30.57 (25,833) 26.74Forfeited/expired (5,495) 43.31 (6,435) 43.82 (8,056) 43.56

Outstanding at end of year 150,149 42.03 174,261 40.05 198,173 38.12

Exercisable at end of year 89,652 40.52 94,643 36.41 97,663 32.56

Stock options outstanding and exercisable at December 31, 2005(a)

Options Outstanding Options ExercisableRange of Exercise Price Options Average Price(b) Average Life(c) Options Average Price(b) Average Life(c)

$14.40 to $21.54 905 $20.01 3.56 yrs. 905 $20.01 3.56 yrs.$23.00 to $33.75 14,559 30.46 3.07 14,398 30.50 3.05$34.00 to $43.50 82,410 39.44 5.34 48,921 39.19 4.10$43.75 to $56.75 52,275 49.77 7.17 25,428 49.48 6.09

150,149 42.03 5.67 89,652 40.52 4.45(a) Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans.

(b) Weighted-average exercise price.

(c) Weighted-average contractual life remaining.

Our RSU Activity(a)

2005 2004Average AverageIntrinsic Average Intrinsic Average

RSUs Value(b) Life(c) RSUs Value(b) Life(c)

Outstanding at beginning of year 2,922 $47.30 – $ –Granted 3,097 53.83 3,077 47.28Converted (91) 48.73 (18) 47.25Forfeited/expired (259) 50.51 (137) 47.25

Outstanding at end of year 5,669 50.70 1.8 yrs. 2,922 47.30 2.2 yrs.(a) RSUs are in thousands.

(b) Weighted-average intrinsic value.

(c) Weighted-average contractual life remaining.

Other stock-based compensation data

Stock Options RSUs2005 2004 2003 2005 2004

Weighted-average fair value of options granted $13.45 $12.04 $11.21Total intrinsic value of options/RSUs exercised/converted(a) $632,603 $667,001 $466,719 $4,974 $914Total intrinsic value of options/RSUs outstanding(a) $2,553,594 $2,062,153 $1,641,505 $334,931 $151,760Total intrinsic value of options exercisable(a) $1,662,198 $1,464,926 $1,348,658(a) In thousands.

At December 31, 2005, there was $315 million of total unrecognized compensation cost related to nonvested share-basedcompensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.6 years.


Our pension plans cover full-time employ-ees in the U.S. and certain internationalemployees. Benefits are determined basedon either years of service or a combinationof years of service and earnings. U.S.retirees are also eligible for medical andlife insurance benefits (retiree medical) ifthey meet age and service requirements.Generally, our share of retiree medicalcosts is capped at specified dollaramounts, which vary based upon years ofservice, with retirees contributing theremainder of the costs. We use aSeptember 30 measurement date and allplan assets and liabilities are generally

reported as of that date. The cost orbenefit of plan changes that increase ordecrease benefits for prior employeeservice (prior service cost) is included inexpense on a straight-line basis over theaverage remaining service period ofemployees expected to receive benefits.

The Medicare Act was signed into law inDecember 2003 and we applied the provi-sions of the Medicare Act to our plans in2005 and 2004. The Medicare Actprovides a subsidy for sponsors of retireemedical plans who offer drug benefitsequivalent to those provided underMedicare. As a result of the Medicare Act,

our 2005 and 2004 retiree medical costswere $11 million and $7 million lower,respectively, and our 2005 and 2004 lia-bilities were reduced by $136 million and$80 million, respectively. We expect our2006 retiree medical costs to be approxi-mately $18 million lower than they other-wise would have been as a result of theMedicare Act.

For additional unaudited information onour pension and retiree medical plans andrelated accounting policies and assump-tions, see “Our Critical Accounting Policies”in Management’s Discussion and Analysis.

Pension Retiree Medical2005 2004 2003 2005 2004 2003 2005 2004 2003

U.S. InternationalWeighted-average assumptionsLiability discount rate........................................................ 5.7% 6.1% 6.1% 5.1% 6.1% 6.1% 5.7% 6.1% 6.1%Expense discount rate........................................................ 6.1% 6.1% 6.7% 6.1% 6.1% 6.4% 6.1% 6.1% 6.7%Expected return on plan assets ......................................... 7.8% 7.8% 8.3% 8.0% 8.0% 8.0% – – –Rate of compensation increases........................................ 4.4% 4.5% 4.5% 4.1% 3.9% 3.8% – – –

Components of benefit expenseService cost....................................................................... $ 213 $ 193 $ 153 $ 32 $ 27 $ 24 $ 40 $ 38 $ 33Interest cost...................................................................... 296 271 245 55 47 39 78 72 73Expected return on plan assets ........................................ (344) (325) (305) (69) (65) (54) – – –Amortization of prior service cost/(benefit)....................... 3 6 6 1 1 – (11) (8) (3)Amortization of experience loss......................................... 106 81 44 15 9 5 26 19 13Benefit expense................................................................. 274 226 143 34 19 14 133 121 116Settlement/curtailment loss ............................................. – 4 – – 1 – – – –Special termination benefits............................................. 21 19 4 – 1 – 2 4 –Total .................................................................................. $ 295 $ 249 $ 147 $ 34 $ 21 $ 14 $135 $125 $116

Note 7 — Pension, Retiree Medical and Savings Plans


Pension Retiree Medical2005 2004 2005 2004 2005 2004

U.S. InternationalChange in projected benefit liabilityLiability at beginning of year $4,968 $4,456 $ 952 $758 $1,319 $1,264Service cost 213 193 32 27 40 38Interest cost 296 271 55 47 78 72Plan amendments – (17) 3 1 (8) (41)Participant contributions – – 10 9 – –Experience loss/(gain) 517 261 203 73 (45) 58Benefit payments (241) (205) (28) (29) (74) (76)Settlement/curtailment loss – (9) – (2) – –Special termination benefits 21 18 – 1 2 4Foreign currency adjustment – – (68) 67 – –Other (3) – 104 – – –Liability at end of year $5,771 $4,968 $1,263 $952 $1,312 $1,319

Liability at end of year for service to date $4,783 $4,164 $1,047 $779

Change in fair value of plan assetsFair value at beginning of year $4,152 $3,558 $ 838 $687 $ – $ –Actual return on plan assets 477 392 142 77 – –Employer contributions/funding 699 416 104 37 74 76Participant contributions – – 10 9 – –Benefit payments (241) (205) (28) (29) (74) (76)Settlement/curtailment loss – (9) – (2) – –Foreign currency adjustment – – (61) 59 – –Other (1) – 94 – – –Fair value at end of year $5,086 $4,152 $1,099 $838 $ – $ –

Funded status as recognized in our Consolidated Balance SheetFunded status at end of year $ (685) $ (817) $(164) $(113) $(1,312) $(1,319)Unrecognized prior service cost/(benefit) 5 9 17 13 (113) (116)Unrecognized experience loss 2,288 2,013 474 380 402 473Fourth quarter benefit payments 5 5 4 7 19 19Net amounts recognized $1,613 $1,210 $ 331 $ 287 $(1,004) $ (943)

Net amounts as recognized in our Consolidated Balance SheetOther assets $2,068 $1,572 $367 $294 $ – $ –Intangible assets – – 1 5 – –Other liabilities (479) (387) (41) (37) (1,004) (943)Accumulated other comprehensive loss 24 25 4 25 – –Net amounts recognized $1,613 $1,210 $331 $287 $(1,004) $(943)

Components of increase in unrecognized experience lossDecrease in discount rate $ 365 $ – $194 $ 4 $ 61 $ –Employee-related assumption changes 57 196 2 65 – 109Liability-related experience different from assumptions 95 65 7 4 (54) 31Actual asset return different from expected return (133) (67) (73) (12) – –Amortization of losses (106) (81) (15) (9) (26) (19)Other, including foreign currency adjustments

and 2003 Medicare Act (3) (5) (22) 26 (52) (82)Total $ 275 $108 $ 93 $ 78 $(71) $ 39

Selected information for plans with liability for service to date in excess of plan assetsLiability for service to date $(374) $(320) $(65) $(191) $(1,312) $(1,319)Projected benefit liability $(815) $(685) $(84) $(227) $(1,312) $(1,319)Fair value of plan assets $8 $11 $33 $161 $– $–

Of the total projected pension benefit liability at year-end 2005, $765 million relates to plans that we do not fund because thefunding of such plans does not receive favorable tax treatment.


Savings PlansOur U.S. employees are eligible to partici-pate in 401(k) savings plans, which arevoluntary defined contribution plans. The

plans are designed to help employeesaccumulate additional savings for retire-ment. We make matching contributions ona portion of eligible pay based on years of

service. In 2005 and 2004, our matchingcontributions were $52 million and $35million, respectively.

Future Benefit PaymentsOur estimated future benefit payments are as follows:

2006 2007 2008 2009 2010 2011-15Pension $235 $255 $275 $300 $330 $2,215Retiree medical $85 $90 $90 $95 $100 $545

These future benefits to beneficiaries include payments from both funded and unfunded pension plans.

Pension AssetsThe expected return on pension planassets is based on our historical experi-ence, our pension plan investment guide-lines, and our expectations for long-termrates of return. We use a market-relatedvalue method that recognizes each year’sasset gain or loss over a five-year period.Therefore, it takes five years for the gain orloss from any one year to be fully includedin the value of pension plan assets that isused to calculate the expected return. Our

pension plan investment guidelines areestablished based upon an evaluation ofmarket conditions, tolerance for risk andcash requirements for benefit payments.Our investment objective is to ensure thatfunds are available to meet the plans’ ben-efit obligations when they are due. Ourinvestment strategy is to prudently investplan assets in high-quality and diversifiedequity and debt securities to achieve ourlong-term return expectation. Our target

allocation and actual pension plan assetallocations for the plan years 2005 and2004, are below.

Pension assets include approximately5.5 million shares of PepsiCo commonstock with a market value of $311 millionin 2005, and 5.5 million shares with amarket value of $267 million in 2004. Ourinvestment policy limits the investment inPepsiCo stock at the time of investment to10% of the fair value of plan assets.

1% Increase 1% Decrease2005 service and interest cost components $3 $(2)2005 benefit liability $38 $(33)

Actual AllocationAsset Category Target Allocation 2005 2004

Equity securities 60% 60% 60%Debt securities 40% 39% 39%Other, primarily cash – 1% 1%Total 100% 100% 100%

Our most significant noncontrolled bottlingaffiliates are PBG and PAS. Approximately10% of our net revenue in 2005, 2004and 2003 reflects sales to PBG.

The Pepsi Bottling GroupIn addition to approximately 41% and42% of PBG’s outstanding common stockthat we own at year-end 2005 and 2004,respectively, we own 100% of PBG’s classB common stock and approximately 7% ofthe equity of Bottling Group, LLC, PBG’s

principal operating subsidiary. This givesus economic ownership of approximately45% and 46% of PBG’s combined opera-tions at year-end 2005 and 2004, respec-tively. In 2005, bottling equity incomeincludes $126 million of pre-tax gains onour sales of PBG stock.

Note 8 — Noncontrolled Bottling Affiliates

Retiree Medical Cost Trend RatesAn average increase of 10% in the cost ofcovered retiree medical benefits isassumed for 2006. This average increaseis then projected to decline gradually to

5% in 2010 and thereafter. Theseassumed health care cost trend rates havean impact on the retiree medical planexpense and liability. However, the cap onour share of retiree medical costs limits

the impact. A 1 percentage point changein the assumed health care trend ratewould have the following effects:


Such amounts are settled on termsconsistent with other trade receivables andpayables. See Note 9 regarding our guaran-tee of certain PBG debt.

In addition, we coordinate, on an aggre-gate basis, the negotiation and purchase ofsweeteners and other raw materials

requirements for certain of our bottlerswith suppliers. Once we have negotiatedthe contracts, the bottlers order and takedelivery directly from the supplier and paythe suppliers directly. Consequently, thesetransactions are not reflected in ourconsolidated financial statements. As the

contracting party, we could be liable tothese suppliers in the event of any nonpay-ment by our bottlers, but we consider thisexposure to be remote.

2005 2004 2003Net revenue $4,633 $ 4,170 $3,699Selling, general and administrative expenses $143 $114 $128Accounts and notes receivable $178 $157Accounts payable and other current liabilities $117 $95

Our investment in PBG, which includesthe related goodwill, was $400 million and$321 million higher than our ownershipinterest in their net assets at year-end2005 and 2004, respectively. Based uponthe quoted closing price of PBG shares atyear-end 2005 and 2004, the calculatedmarket value of our shares in PBG, exclud-ing our investment in Bottling Group, LLC,exceeded our investment balance byapproximately $1.5 billion and $1.7billion, respectively.

PepsiAmericasAt year-end 2005 and 2004, we owned approximately 43% and 41% of PepsiAmericas,respectively, and their summarized financial information is as follows:

2005 2004 2003Current assets $ 598 $ 530Noncurrent assets 3,456 3,000

Total assets $4,054 $3,530

Current liabilities $ 722 $ 521Noncurrent liabilities 1,763 1,386

Total liabilities $2,485 $1,907

Our investment $968 $924

Net revenue $3,726 $3,345 $3,237Gross profit $1,562 $1,423 $1,360Operating profit $393 $340 $316Net income $195 $182 $158

PBG’s summarized financial information is as follows:

2005 2004 2003Current assets $ 2,412 $ 2,183Noncurrent assets 9,112 8,754

Total assets $11,524 $10,937Current liabilities $2,598 $1,725Noncurrent liabilities 6,387 6,818Minority interest 496 445

Total liabilities $9,481 $8,988

Our investment $1,738 $1,594

Net revenue $11,885 $10,906 $10,265Gross profit $5,632 $5,250 $5,050Operating profit $1,023 $976 $956Net income $466 $457 $416

Related Party TransactionsOur significant related party transactionsinvolve our noncontrolled bottling affiliates.We sell concentrate to these affiliates,which is used in the production of carbon-ated soft drinks and non-carbonated bever-

ages. We also sell certain finished goodsto these affiliates and we receive royaltiesfor the use of our trademarks for certainproducts. Sales of concentrate andfinished goods are reported net of bottlerfunding. For further unaudited information

on these bottlers, see “Our Customers” inManagement’s Discussion and Analysis.These transactions with our bottlingaffiliates are reflected in our consolidatedfinancial statements as follows:

Our investment in PAS, which includesthe related goodwill, was $292 millionand $253 million higher than our owner-ship interest in their net assets at year-end2005 and 2004, respectively. Based uponthe quoted closing price of PAS shares atyear-end 2005 and 2004, the calculatedmarket value of our shares in PepsiAmericasexceeded our investment balance byapproximately $364 million and$277 million, respectively.

In January 2005, PAS acquired aregional bottler, Central InvestmentCorporation. The table above includes theresults of Central Investment Corporationfrom the transaction date forward.


Note 9 — Debt Obligations and Commitments

Short-term borrowings are reclassified tolong-term when we have the intent andability, through the existence of the unusedlines of credit, to refinance these borrow-ings on a long-term basis. At year-end2005, we maintained $2.1 billion incorporate lines of credit subject to normalbanking terms and conditions. These creditfacilities support short-term debt issuancesand remained unused as of December 31,2005. Of the $2.1 billion, $1.35 billionexpires in May 2006 with the remaining$750 million expiring in June 2009.

In addition, $181 million of our debtwas outstanding on various lines of creditmaintained for our international divisions.

These lines of credit are subject to normalbanking terms and conditions and arecommitted to the extent of our borrowings.

Interest Rate SwapsWe entered into interest rate swaps in2004 to effectively convert the interest rateof a specific debt issuance from a fixedrate of 3.2% to a variable rate. The vari-able weighted-average interest rate that wepay is linked to LIBOR and is subject tochange. The notional amount of the inter-est rate swaps outstanding at December31, 2005 and December 25, 2004 was$500 million. The terms of the interestrate swaps match the terms of the debtthey modify. The swaps mature in 2007.

At December 31, 2005, approximately78% of total debt, after the impact of theassociated interest rate swaps, was exposedto variable interest rates, compared to 67%at December 25, 2004. In addition to vari-able rate long-term debt, all debt with matu-rities of less than one year is categorizedas variable for purposes of this measure.

Cross Currency Interest Rate SwapsIn 2004, we entered into a cross currencyinterest rate swap to hedge the currencyexposure on U.S. dollar denominated debtof $50 million held by a foreign affiliate.The terms of this swap match the terms ofthe debt it modifies. The swap matures in2008. The unrecognized gain related tothis swap was less than $1 million atDecember 31, 2005, resulting in a U.S.dollar liability of $50 million. At December25, 2004, the unrecognized loss related tothis swap was $3 million, resulting in aU.S. dollar liability of $53 million. Wehave also entered into cross currencyinterest rate swaps to hedge the currencyexposure on U.S. dollar denominatedintercompany debt of $125 million. Theterms of the swaps match the terms of thedebt they modify. The swaps mature overthe next two years. The net unrecognizedgain related to these swaps was $5 millionat December 31, 2005. The net unrecog-nized loss related to these swaps was lessthan $1 million at December 25, 2004.

2005 2004Short-term debt obligationsCurrent maturities of long-term debt $ 143 $ 160Commercial paper (3.3% and 1.6%) 3,140 1,287Other borrowings (7.4% and 6.6%) 356 357Amounts reclassified to long-term debt (750) (750)

$2,889 $1,054

Long-term debt obligationsShort-term borrowings, reclassified $ 750 $ 750Notes due 2006-2026 (5.4% and 4.7%) 1,161 1,274Zero coupon notes, $475 million due 2006-2012 (13.4%) 312 321Other, due 2006-2014 (6.3% and 6.2%) 233 212

2,456 2,557Less: current maturities of long-term debt obligations (143) (160)

$2,313 $2,397

The interest rates in the above table reflect weighted-average rates as of year-end.

Long-Term Contractual Commitments

Payments Due by Period Total 2006 2007-2008 2009-2010 2011 and beyondLong-term debt obligations(a) .......................................................... $2,313 $ – $1,052 $ 876 $ 385Operating leases ............................................................................. 769 187 253 132 197Purchasing commitments(b) ............................................................ 4,533 1,169 1,630 775 959Marketing commitments.................................................................. 1,487 412 438 381 256Other commitments......................................................................... 99 82 10 6 1

$9,201 $1,850 $3,383 $2,170 $1,798

(a) Excludes current maturities of long-term debt of $143 million which are classified within current liabilities.

(b) Includes approximately $13 million of long-term commitments which are reflected in other liabilities in our Consolidated Balance Sheet.

The above table reflects non-cancelable commitments as of December 31, 2005 based on year-end foreign exchange rates.


Most long-term contractual commit-ments, except for our long-term debtobligations, are not recorded in ourConsolidated Balance Sheet. Non-cance-lable operating leases primarily representbuilding leases. Non-cancelable purchasingcommitments are primarily for oranges andorange juices to be used for our Tropicanabrand beverages. Non-cancelable marketingcommitments primarily are for sportsmarketing and with our fountain customers.Bottler funding is not reflected in ourlong-term contractual commitments as it isnegotiated on an annual basis. See Note 7regarding our pension and retiree medical

obligations and discussion below regardingour commitments to noncontrolled bottlingaffiliates and former restaurant operations.

Off-Balance Sheet ArrangementsIt is not our business practice to enter intooff-balance sheet arrangements, other thanin the normal course of business, nor isit our policy to issue guarantees to ourbottlers, noncontrolled affiliates or thirdparties. However, certain guarantees werenecessary to facilitate the separation of ourbottling and restaurant operations from us.In connection with these transactions, wehave guaranteed $2.3 billion of BottlingGroup, LLC’s long-term debt through 2012and $28 million of YUM! Brands, Inc.(YUM) outstanding obligations, primarily

property leases, through 2020. The termsof our Bottling Group, LLC debt guaranteeare intended to preserve the structure ofPBG’s separation from us and our paymentobligation would be triggered if BottlingGroup, LLC failed to perform under thesedebt obligations or the structure signifi-cantly changed. Our guarantees of certainobligations ensured YUM’s continued use ofcertain properties. These guarantees wouldrequire our cash payment if YUM failed toperform under these lease obligations.

See “Our Liquidity, Capital Resourcesand Financial Position” in Management’sDiscussion and Analysis for furtherunaudited information on our borrowings.

We are exposed to the risk of loss arisingfrom adverse changes in:• commodity prices, affecting the cost of

our raw materials and energy,• foreign exchange risks,• interest rates,• stock prices, and• discount rates affecting the measure-

ment of our pension and retiree medicalliabilities.In the normal course of business, we

manage these risks through a variety ofstrategies, including the use of derivatives.Certain derivatives are designated as eithercash flow or fair value hedges and qualifyfor hedge accounting treatment, while oth-ers do not qualify and are marked to marketthrough earnings. See “Our BusinessRisks” in Management’s Discussion andAnalysis for further unaudited informationon our business risks.

For cash flow hedges, changes in fairvalue are deferred in accumulated othercomprehensive loss within shareholders’equity until the underlying hedged item isrecognized in net income. For fair valuehedges, changes in fair value are recognizedimmediately in earnings, consistent with theunderlying hedged item. Hedging transac-tions are limited to an underlying exposure.As a result, any change in the value of ourderivative instruments would be substan-tially offset by an opposite change in thevalue of the underlying hedged items.Hedging ineffectiveness and a net earnings

impact occur when the change in the valueof the hedge does not offset the change inthe value of the underlying hedged item. Ifthe derivative instrument is terminated, wecontinue to defer the related gain or lossand include it as a component of the cost ofthe underlying hedged item. Upon determi-nation that the underlying hedged itemwill not be part of an actual transaction, werecognize the related gain or loss in netincome in that period.

We also use derivatives that do notqualify for hedge accounting treatment.We account for such derivatives at marketvalue with the resulting gains and lossesreflected in our income statement. We donot use derivative instruments for tradingor speculative purposes and we limit ourexposure to individual counterparties tomanage credit risk.

Commodity PricesWe are subject to commodity price riskbecause our ability to recover increasedcosts through higher pricing may belimited in the competitive environment inwhich we operate. This risk is managedthrough the use of fixed-price purchaseorders, pricing agreements, geographicdiversity and derivatives. We use deriva-tives, with terms of no more than twoyears, to economically hedge price fluctua-tions related to a portion of our anticipatedcommodity purchases, primarily for naturalgas and diesel fuel. For those derivativesthat are designated as cash flow hedges,

any ineffectiveness is recorded immedi-ately. However, our commodity cash flowhedges have not had any significant inef-fectiveness for all periods presented. Weclassify both the earnings and cash flowimpact from these derivatives consistentwith the underlying hedged item. Duringthe next 12 months, we expect to reclas-sify gains of $24 million related to cashflow hedges from accumulated othercomprehensive loss into net income.

Foreign ExchangeOur operations outside of the U.S. generateover a third of our net revenue of whichMexico, the United Kingdom and Canadacomprise nearly 20%. As a result, we areexposed to foreign currency risks fromunforeseen economic changes and politicalunrest. On occasion, we enter into hedges,primarily forward contracts with terms of nomore than two years, to reduce the effect offoreign exchange rates. Ineffectiveness onthese hedges has not been material.

Interest RatesWe centrally manage our debt and invest-ment portfolios considering investmentopportunities and risks, tax consequencesand overall financing strategies. We mayuse interest rate and cross currencyinterest rate swaps to manage our overallinterest expense and foreign exchange risk.These instruments effectively change theinterest rate and currency of specific debtissuances. These swaps are entered into

Note 10 — Risk Management


concurrently with the issuance of the debtthat they are intended to modify. Thenotional amount, interest payment andmaturity date of the swaps match theprincipal, interest payment and maturitydate of the related debt. These swaps areentered into only with strong creditworthycounterparties, are settled on a net basisand are of relatively short duration.

Stock PricesThe portion of our deferred compensationliability that is based on certain marketindices and on our stock price is subjectto market risk. We hold mutual fundinvestments and prepaid forward contractsto manage this risk. Changes in the fairvalue of these investments and contractsare recognized immediately in earningsand are offset by changes in the relatedcompensation liability.

Fair ValueAll derivative instruments are recognized inour Consolidated Balance Sheet at fairvalue. The fair value of our derivative instru-ments is generally based on quoted marketprices. Book and fair values of our derivativeand financial instruments are as follows:

2005 2004Book Value Fair Value Book Value Fair Value

AssetsCash and cash equivalents(a) .................................................................................. $1,716 $1,716 $1,280 $1,280Short-term investments(b) ........................................................................................ $3,166 $3,166 $2,165 $2,165Forward exchange contracts(c) ................................................................................. $19 $19 $8 $8Commodity contracts(d) ............................................................................................ $41 $41 $7 $7Prepaid forward contract(e) ...................................................................................... $107 $107 $120 $120Cross currency interest rate swaps(f) ....................................................................... $6 $6 $– $–LiabilitiesForward exchange contracts(c) ................................................................................. $15 $15 $35 $35Commodity contracts(d) ............................................................................................ $3 $3 $8 $8Debt obligations....................................................................................................... $5,202 $5,378 $3,451 $3,676Interest rate swaps(g)............................................................................................... $9 $9 $1 $1Cross currency interest rate swaps(f) ...................................................................... $– $– $3 $3Included in our Consolidated Balance Sheet under the captions noted above or as indicated below. In addition, derivatives are designated as accounting hedges unless otherwise noted below.

(a) Book value approximates fair value due to the short maturity.

(b) Principally short-term time deposits and includes $124 million at December 31, 2005 and $118 million at December 25, 2004 of mutual fund investments used to manage a portion of market risk arising from ourdeferred compensation liability.

(c) 2005 asset includes $14 million related to derivatives not designated as accounting hedges. Assets are reported within current assets and other assets and liabilities are reported within current liabilities andother liabilities.

(d) 2005 asset includes $2 million related to derivatives not designated as accounting hedges and the liability relates entirely to derivatives not designated as accounting hedges. Assets are reported within currentassets and other assets and liabilities are reported within current liabilities and other liabilities.

(e) Included in current assets and other assets.

(f ) Asset included within other assets and liability included in long-term debt.

(g) Reported in other liabilities.

This table excludes guarantees, including our guarantee of $2.3 billion of Bottling Group, LLC’s long-term debt. The guarantee had afair value of $47 million at December 31, 2005 and $46 million at December 25, 2004 based on an external estimate of the cost tous of transferring the liability to an independent financial institution. See Note 9 for additional information on our guarantees.

Basic net income per common share is netincome available to common shareholdersdivided by the weighted average of com-mon shares outstanding during the period.Diluted net income per common share iscalculated using the weighted average ofcommon shares outstanding adjusted toinclude the effect that would occur if

in-the-money employee stock options wereexercised and RSUs and preferred shareswere converted into common shares.Options to purchase 3.0 million shares in2005, 7.0 million shares in 2004 and49.0 million shares in 2003 were notincluded in the calculation of dilutedearnings per common share because these

options were out-of-the-money. Out-of-the-money options had average exercise pricesof $53.77 in 2005, $52.88 in 2004 and$48.27 in 2003.

Note 11 — Net Income per Common Share from Continuing Operations


Comprehensive income is a measure ofincome which includes both net incomeand other comprehensive income or loss.Other comprehensive loss results fromitems deferred on the balance sheet inshareholders’ equity. Other comprehensive(loss)/income was $(167) million in 2005,$381 million in 2004, and $405 millionin 2003. The accumulated balances foreach component of other comprehensiveloss were as follows:

2005 2004 2003Currency translation adjustment $ (971) $(720) $(1,121)Cash flow hedges, net of tax(a) 27 (19) (12)Minimum pension liability adjustment(b) (138) (154) (135)Unrealized gain on securities, net of tax 31 7 1Other (2) – –Accumulated other comprehensive loss $(1,053) $(886) $(1,267)

(a) Includes net commodity gains of $55 million in 2005. Also includes no impact in 2005, $6 million gain in 2004 and $8 million gain in 2003for our share of our equity investees’ accumulated derivative activity. Deferred gains/(losses) reclassified into earnings were $8 million in2005, $(10) million in 2004 and no impact in 2003.

(b) Net of taxes of $72 million in 2005, $77 million in 2004 and $67 million in 2003. Also, includes $120 million in 2005, $121 million in 2004and $110 million in 2003 for our share of our equity investees’ minimum pension liability adjustments.

As of December 31, 2005 and December25, 2004, there were 3.6 billion shares ofcommon stock and 3 million shares ofconvertible preferred stock authorized. Thepreferred stock was issued only for anemployee stock ownership plan (ESOP)established by Quaker and these sharesare redeemable for common stock by theESOP participants. The preferred stockaccrues dividends at an annual rate of$5.46 per share. At year-end 2005 and

2004, there were 803,953 preferredshares issued and 354,853 and 424,853shares outstanding, respectively. Eachshare is convertible at the option of theholder into 4.9625 shares of commonstock. The preferred shares may be calledby us upon written notice at $78 per shareplus accrued and unpaid dividends.

As of December 31, 2005, 0.3 millionoutstanding shares of preferred stock witha fair value of $104 million and 17 million

shares of common stock were held in theaccounts of ESOP participants. As ofDecember 25, 2004, 0.4 million outstand-ing shares of preferred stock with a fairvalue of $110 million and 18 millionshares of common stock were held in theaccounts of ESOP participants. Quakermade the final award to its ESOP plan inJune 2001.

Note 12 — Preferred and Common Stock

2005 2004 2003Income Shares(a) Income Shares(a) Income Shares(a)

Net income $4,078 $4,174 $3,568Preferred shares:

Dividends (2) (3) (3)Redemption premium (16) (22) (12)

Net income available for common shareholders $4,060 1,669 $4,149 1,696 $3,553 1,718

Basic net income per common share $2.43 $2.45 $2.07

Net income available for common shareholders $4,060 1,669 $4,149 1,696 $3,553 1,718Dilutive securities:

Stock options and RSUs – 35 – 31 – 17ESOP convertible preferred stock 18 2 24 2 15 3Unvested stock awards – – – – – 1

Diluted $4,078 1,706 $4,173 1,729 $3,568 1,739

Diluted net income per common share $2.39 $2.41 $2.05

(a) Weighted-average common shares outstanding.

2005 2004 2003Shares Amount Shares Amount Shares Amount

Preferred stock 0.8 $41 0.8 $41 0.8 $41

Repurchased preferred stockBalance, beginning of year 0.4 $ 90 0.3 $63 0.2 $48

Redemptions 0.1 19 0.1 27 0.1 15Balance, end of year 0.5 $110* 0.4 $90 0.3 $63

*Does not sum due to rounding.

Note 13 — Accumulated Other Comprehensive Loss

The computations of basic and diluted net income per common share from continuing operations are as follows:


2005 2004 2003Accounts receivableTrade receivables ..................................................... $2,718 $2,505Other receivables ..................................................... 618 591

3,336 3,096Allowance, beginning of year ................................... 97 105 $116

Net amounts (credited)/charged to expense ........ (1) 18 32Deductions(a) ........................................................ (22) (25) (43)Other(b) ................................................................. 1 (1) –

Allowance, end of year ............................................. 75 97 $105Net receivables ........................................................ $3,261 $2,999

Inventory(c)

Raw materials.......................................................... $ 738 $ 665Work-in-process ....................................................... 112 156Finished goods ......................................................... 843 720

$1,693 $1,541

Accounts payable and other current liabilitiesAccounts payable ..................................................... $1,799 $1,731Accrued marketplace spending................................ 1,383 1,285Accrued compensation and benefits ........................ 1,062 961Dividends payable.................................................... 431 387Insurance accruals .................................................. 136 131Other current liabilities............................................ 1,160 1,104

$5,971 $5,599

Other liabilitiesReserves for income taxes........................................ $1,884 $1,567Other ........................................................................ 2,439 2,532

$4,323 $4,099

Other supplemental informationRent expense............................................................ $228 $245 $231Interest paid ............................................................ $213 $137 $147Income taxes paid, net of refunds............................ $1,258 $1,833 $1,530Acquisitions(d)

Fair value of assets acquired............................... $ 1,089 $ 78 $178Cash paid and debt issued.................................. (1,096) (64) (71)SVE minority interest eliminated.......................... 216 – –Liabilities assumed.............................................. $ 209 $ 14 $107

(a) Includes accounts written off.

(b) Includes collections of previously written-off accounts and currency translation effects.

(c) Inventories are valued at the lower of cost or market. Cost is determined using the average, first-in, first-out (FIFO) or last-in, first-out(LIFO) methods. Approximately 17% in 2005 and 15% in 2004 of the inventory cost was computed using the LIFO method. The differencesbetween LIFO and FIFO methods of valuing these inventories were not material.

(d) In 2005, these amounts include the impact of our acquisition of General Mills, Inc.’s 40.5% ownership interest in SVE for $750 million. Theexcess of our purchase price over the fair value of net assets acquired is $250 million and is included in goodwill. We also reacquired rightsto distribute global brands for $263 million which is included in other nonamortizable intangible assets.

Note 14 — Supplemental Financial Information


ADDITIONAL INFORMATIONIn addition to the financial statements and accompanying notes, companies are re-quired to provide a report on internal control over financial reporting and to havean auditor’s report on the financial statements. In addition, PepsiCo has provideda report indicating that financial reporting is management’s responsibility. Finally,PepsiCo also provides selected financial data it believes is useful.The two requiredreports are further explained below.

Management’s Report on Internal Control overFinancial ReportingThe Sarbanes-Oxley Act of 2002 requires managers of publicly traded companiesto establish and maintain systems of internal control over the company’s financialreporting processes. In addition, management must express its responsibility for fi-nancial reporting, and it must provide certifications regarding the accuracy of thefinancial statements.

Auditor’s ReportAll publicly held corporations, as well as many other enterprises and organizationsengage the services of independent certified public accountants for the purpose ofobtaining an objective, expert report on their financial statements. Based on acomprehensive examination of the company’s accounting system, accountingrecords, and the financial statements, the outside CPA issues the auditor’s report.

The standard auditor’s report identifies who and what was audited and indi-cates the responsibilities of management and the auditor relative to the financialstatements. It states that the audit was conducted in accordance with generally ac-cepted auditing standards and discusses the nature and limitations of the audit. Itthen expresses an informed opinion as to (1) the fairness of the financial state-ments and (2) their conformity with generally accepted accounting principles. Italso expresses an opinion regarding the effectiveness of the company’s internalcontrols. All of this additional information for PepsiCo is provided on the follow-ing pages.

Additional Information A27

At PepsiCo, our actions — the actions of all our associates — aregoverned by our Worldwide Code of Conduct. This code is clearlyaligned with our stated values — a commitment to sustainedgrowth, through empowered people, operating with responsibilityand building trust. Both the code and our core values enable us tooperate with integrity — both within the letter and the spirit ofthe law. Our code of conduct is reinforced consistently at all levelsand in all countries. We have maintained strong governancepolicies and practices for many years.

The management of PepsiCo is responsible for the objectivityand integrity of our consolidated financial statements. The AuditCommittee of the Board of Directors has engaged independentregistered public accounting firm, KPMG LLP, to audit ourconsolidated financial statements and they have expressed anunqualified opinion.

We are committed to providing timely, accurate and understand-able information to investors. Our commitment encompassesthe following:

Maintaining strong controls over financial reporting. Our system ofinternal control is based on the control criteria framework of theCommittee of Sponsoring Organizations of the TreadwayCommission published in their report titled, Internal Control —Integrated Framework. The system is designed to provide reason-able assurance that transactions are executed as authorized andaccurately recorded; that assets are safeguarded; and thataccounting records are sufficiently reliable to permit the prepara-tion of financial statements that conform in all material respectswith accounting principles generally accepted in the U.S. Wemaintain disclosure controls and procedures designed to ensurethat information required to be disclosed in reports under theSecurities Exchange Act of 1934 is recorded, processed, summa-rized and reported within the specified time periods. We monitorthese internal controls through self-assessments and an ongoingprogram of internal audits. Our internal controls are reinforcedthrough our Worldwide Code of Conduct, which sets forth ourcommitment to conduct business with integrity, and within boththe letter and the spirit of the law.

Exerting rigorous oversight of the business. We continuously reviewour business results and strategies. This encompasses financialdiscipline in our strategic and daily business decisions. OurExecutive Committee is actively involved — from understandingstrategies and alternatives to reviewing key initiatives andfinancial performance. The intent is to ensure we remain objectivein our assessments, constructively challenge our approach topotential business opportunities and issues, and monitor resultsand controls.

Engaging strong and effective Corporate Governance from our Board ofDirectors. We have an active, capable and diligent Board thatmeets the required standards for independence, and we welcomethe Board’s oversight as a representative of our shareholders. Our

Audit Committee comprises independent directors with thefinancial literacy, knowledge and experience to provide appropriateoversight. We review our critical accounting policies, financialreporting and internal control matters with them and encouragetheir direct communication with KPMG LLP, with our GeneralAuditor, and with our General Counsel. In 2005, we named asenior compliance officer to lead and coordinate our compliancepolicies and practices.

Providing investors with financial results that are complete,transparent and understandable. The consolidated financial state-ments and financial information included in this report are theresponsibility of management. This includes preparing thefinancial statements in accordance with accounting principlesgenerally accepted in the U.S., which require estimates based onmanagement’s best judgment.

PepsiCo has a strong history of doing what’s right. We realize thatgreat companies are built on trust, strong ethical standards andprinciples. Our financial results are delivered from that culture ofaccountability, and we take responsibility for the quality andaccuracy of our financial reporting.

Peter A. BridgmanSenior Vice President and Controller

Indra K. NooyiPresident and Chief Financial Officer

Steven S ReinemundChairman of the Boardand Chief Executive Officer

Management’s Responsibility for Financial ReportingTo Our Shareholders:


Our management is responsible for establishing and maintainingadequate internal control over financial reporting, as such term isdefined in Rule 13a-15(f) of the Exchange Act. Under the supervi-sion and with the participation of our management, including ourChief Executive Officer and Chief Financial Officer, we conductedan evaluation of the effectiveness of our internal control over finan-cial reporting based upon the framework in Internal Control —Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on thatevaluation, our management concluded that our internal controlover financial reporting is effective as of December 31, 2005.

KPMG LLP, an independent registered public accounting firm, hasaudited the consolidated financial statements included in thisAnnual Report and, as part of their audit, has issued their report,included herein, (1) on our management’s assessment of the effec-tiveness of our internal controls over financial reporting and (2) onthe effectiveness of our internal control over financial reporting.

Management’s Report on Internal Control over Financial ReportingTo Our Shareholders:

Peter A. BridgmanSenior Vice President and Controller

Indra K. NooyiPresident and Chief Financial Officer

Steven S ReinemundChairman of the Boardand Chief Executive Officer

Additional Information A29

Report of Independent Registered Public Accounting Firm

We have audited the accompanying Consolidated Balance Sheet ofPepsiCo, Inc. and Subsidiaries as of December 31, 2005 andDecember 25, 2004 and the related Consolidated Statements ofIncome, Cash Flows and Common Shareholders’ Equity for each ofthe years in the three-year period ended December 31, 2005. Wehave also audited management’s assessment, included inManagement’s Report on Internal Control over FinancialReporting, that PepsiCo, Inc. and Subsidiaries maintainedeffective internal control over financial reporting as ofDecember 31, 2005, based on criteria established in InternalControl — Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO).PepsiCo, Inc.’s management is responsible for these consolidatedfinancial statements, for maintaining effective internal controlover financial reporting, and for its assessment of the effective-ness of internal control over financial reporting. Our responsibilityis to express an opinion on these consolidated financial state-ments, an opinion on management’s assessment, and an opinionon the effectiveness of PepsiCo, Inc.’s internal control overfinancial reporting based on our audits.

We conducted our audits in accordance with the standards of thePublic Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits toobtain reasonable assurance about whether the financialstatements are free of material misstatement and whether effectiveinternal control over financial reporting was maintained in all mate-rial respects. Our audit of financial statements included examining,on a test basis, evidence supporting the amounts and disclosuresin the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluat-ing the overall financial statement presentation. Our audit ofinternal control over financial reporting included obtaining anunderstanding of internal control over financial reporting, evaluat-ing management’s assessment, testing and evaluating the designand operating effectiveness of internal control, and performingsuch other procedures as we considered necessary in the circum-stances. We believe that our audits provide a reasonable basis forour opinions.

A company’s internal control over financial reporting is aprocess designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control overfinancial reporting includes those policies and procedures that (1)pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions ofthe assets of the company; (2) provide reasonable assurance thattransactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted

accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizationsof management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over finan-cial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods aresubject to the risk that controls may become inadequate becauseof changes in conditions, or that the degree of compliance withthe policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred toabove present fairly, in all material respects, the financial positionof PepsiCo, Inc. and Subsidiaries as of December 31, 2005 andDecember 25, 2004, and the results of their operations and theircash flows for each of the years in the three-year period endedDecember 31, 2005, in conformity with United States generallyaccepted accounting principles. Also, in our opinion, manage-ment’s assessment that PepsiCo, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2005,is fairly stated, in all material respects, based on criteriaestablished in Internal Control — Integrated Framework issued byCOSO. Furthermore, in our opinion, PepsiCo, Inc. maintained, inall material respects, effective internal control over financialreporting as of December 31, 2005, based on criteria establishedin Internal Control — Integrated Framework issued by COSO.

KPMG LLPNew York, New YorkFebruary 24, 2006

Board of Directors and Shareholders PepsiCo, Inc.:


First Second Third FourthQuarterly Quarter Quarter Quarter QuarterNet revenue2005 $6,585 $7,697 $8,184 $10,0962004 $6,131 $7,070 $7,257 $8,803Gross profit(a)

2005 $3,715 $4,383 $4,669 $5,6192004 $3,466 $4,039 $4,139 $4,9432005 restructuring charges(b)

2005 – – – $832004 restructuring and

impairment charges(c)

2004 – – – $150AJCA tax charge(d)

2005 – – $468 $(8)Net income(e)

2005 $912 $1,194 $864 $1,1082004 $804 $1,059 $1,364 $985Net income per common

share — basic(e)

2005 $0.54 $0.71 $0.52 $0.662004 $0.47 $0.62 $0.80 $0.58Net income per common

share — diluted(e)

2005 $0.53 $0.70 $0.51 $0.652004 $0.46 $0.61 $0.79 $0.58Cash dividends declared per

common share2005 $0.23 $0.26 $0.26 $0.262004 $0.16 $0.23 $0.23 $0.232005 stock price per share(f)

High $55.71 $57.20 $56.73 $60.34Low $51.34 $51.78 $52.07 $53.55Close $52.62 $55.52 $54.65 $59.082004 stock price per share(f)

High $53.00 $55.48 $55.71 $53.00Low $45.30 $50.28 $48.41 $47.37Close $50.93 $54.95 $50.84 $51.94The first, second, and third quarters consist of 12 weeks and the fourth quarter consists of 16 weeks in 2004and 17 weeks in 2005.

(a) Reflects net reclassifications in all periods from cost of sales to selling, general and administrativeexpenses related to the alignment of certain accounting policies in connection with our ongoing BPTinitiative. See Note 1.

(b) The 2005 restructuring charges were $83 million ($55 million or $0.03 per share after-tax). See Note 3.

(c) The 2004 restructuring and impairment charges were $150 million ($96 million or $0.06 per shareafter-tax). See Note 3.

(d) Represents income tax expense associated with the repatriation of earnings in connection with the AJCA.See Note 5.

(e) Fourth quarter 2004 net income reflects a tax benefit from discontinued operations of $38 million or$0.02 per share. See Note 5.

(f) Represents the composite high and low sales price and quarterly closing prices for one share of PepsiCocommon stock.

Five-Year Summary 2005 2004 2003Net revenue $32,562 $29,261 $26,971Income from continuing operations $4,078 $4,174 $3,568Net income $4,078 $4,212 $3,568Income per common share — basic,

continuing operations $2.43 $2.45 $2.07Income per common share — diluted,

continuing operations $2.39 $2.41 $2.05Cash dividends declared per common share $1.01 $0.850 $0.630Total assets $31,727 $27,987 $25,327Long-term debt $2,313 $2,397 $1,702Return on invested capital(a) 22.7% 27.4% 27.5%

Five-Year Summary (Cont.) 2002 2001Net revenue $25,112 $23,512Net income $3,000 $2,400Income per common share — basic $1.69 $1.35Income per common share — diluted $1.68 $1.33Cash dividends declared per common share $0.595 $0.575Total assets $23,474 $21,695Long-term debt $2,187 $2,651Return on invested capital(a) 25.7% 22.1%

(a) Return on invested capital is defined as adjusted net income divided by the sum of averageshareholders’ equity and average total debt. Adjusted net income is defined as net income plus netinterest expense after tax. Net interest expense after tax was $62 million in 2005, $60 million in2004, $72 million in 2003, $93 million in 2002, and $99 million in 2001.

• As a result of the adoption of SFAS 142, Goodwill and Other Intangible Assets, and the consolidationof SVE in 2002, the data provided above is not comparable.

• Includes restructuring and impairment charges of:

2005 2004 2003 2001

Pre-tax $83 $150 $147 $31

After-tax $55 $96 $100 $19

Per share $0.03 $0.06 $0.06 $0.01

• Includes Quaker merger-related costs of:

2003 2002 2001

Pre-tax $59 $224 $356

After-tax $42 $190 $322

Per share $0.02 $0.11 $0.18

• The 2005 fiscal year consisted of fifty-three weeks compared to fifty-two weeks in our normal fiscal

year. The 53rd week increased 2005 net revenue by an estimated $418 million and net income by an

estimated $57 million or $0.03 per share.

• Cash dividends per common share in 2001 are those of pre-merger PepsiCo prior to the effectivedate of the merger.

• In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related toour discontinued restaurant operations which resulted in a tax benefit of $38 million or $0.02per share.

Selected Financial Data (in millions except per share amounts, unaudited)

SPECIMEN FINANCIAL STATEMENTS:

The Coca-Cola Company

Appendix B

B1

THE COCA-COLA COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Year Ended December 31, 2005 2004 2003(In millions except per share data)

NET OPERATING REVENUES $ 23,104 $ 21,742 $ 20,857Cost of goods sold 8,195 7,674 7,776

GROSS PROFIT 14,909 14,068 13,081Selling, general and administrative expenses 8,739 7,890 7,287Other operating charges 85 480 573

OPERATING INCOME 6,085 5,698 5,221Interest income 235 157 176Interest expense 240 196 178Equity income — net 680 621 406Other loss — net (93) (82) (138)Gains on issuances of stock by equity investees 23 24 8

INCOME BEFORE INCOME TAXES 6,690 6,222 5,495Income taxes 1,818 1,375 1,148

NET INCOME $ 4,872 $ 4,847 $ 4,347

BASIC NET INCOME PER SHARE $ 2.04 $ 2.00 $ 1.77

DILUTED NET INCOME PER SHARE $ 2.04 $ 2.00 $ 1.77

AVERAGE SHARES OUTSTANDING 2,392 2,426 2,459Effect of dilutive securities 1 3 3

AVERAGE SHARES OUTSTANDING ASSUMING DILUTION 2,393 2,429 2,462

Refer to Notes to Consolidated Financial Statements.

The financial information herein is reprinted with permission from The Coca-Cola Company 2005Annual Report. The accompanying Notes are an integral part of the consolidated financial state-ments. The complete financial statements are available through a link at the book’s companionwebsite.

B2 Appendix B Specimen Financial Statements: The Coca-Cola Company


CONSOLIDATED BALANCE SHEETS

December 31, 2005 2004(In millions except par value)

ASSETSCURRENT ASSETS

Cash and cash equivalents $ 4,701 $ 6,707Marketable securities 66 61Trade accounts receivable, less allowances of $72 and $69, respectively 2,281 2,244Inventories 1,424 1,420Prepaid expenses and other assets 1,778 1,849

TOTAL CURRENT ASSETS 10,250 12,281

INVESTMENTSEquity method investments:

Coca-Cola Enterprises Inc. 1,731 1,569Coca-Cola Hellenic Bottling Company S.A. 1,039 1,067Coca-Cola FEMSA, S.A. de C.V. 982 792Coca-Cola Amatil Limited 748 736Other, principally bottling companies 2,062 1,733

Cost method investments, principally bottling companies 360 355

TOTAL INVESTMENTS 6,922 6,252

OTHER ASSETS 2,648 2,981PROPERTY, PLANT AND EQUIPMENT — net 5,786 6,091TRADEMARKS WITH INDEFINITE LIVES 1,946 2,037GOODWILL 1,047 1,097OTHER INTANGIBLE ASSETS 828 702

TOTAL ASSETS $ 29,427 $ 31,441

LIABILITIES AND SHAREOWNERS’ EQUITYCURRENT LIABILITIES

Accounts payable and accrued expenses $ 4,493 $ 4,403Loans and notes payable 4,518 4,531Current maturities of long-term debt 28 1,490Accrued income taxes 797 709

TOTAL CURRENT LIABILITIES 9,836 11,133

LONG-TERM DEBT 1,154 1,157OTHER LIABILITIES 1,730 2,814DEFERRED INCOME TAXES 352 402SHAREOWNERS’ EQUITY

Common stock, $0.25 par value; Authorized — 5,600 shares;Issued — 3,507 and 3,500 shares, respectively 877 875

Capital surplus 5,492 4,928Reinvested earnings 31,299 29,105Accumulated other comprehensive income (loss) (1,669) (1,348)Treasury stock, at cost — 1,138 and 1,091 shares, respectively (19,644) (17,625)

TOTAL SHAREOWNERS’ EQUITY 16,355 15,935

TOTAL LIABILITIES AND SHAREOWNERS’ EQUITY $ 29,427 $ 31,441


Specimen Financial Statements: The Coca-Cola Company B3


CONSOLIDATED STATEMENTS OF CASH FLOWS

Year Ended December 31, 2005 2004 2003(In millions)

OPERATING ACTIVITIESNet income $ 4,872 $ 4,847 $ 4,347Depreciation and amortization 932 893 850Stock-based compensation expense 324 345 422Deferred income taxes (88) 162 (188)Equity income or loss, net of dividends (446) (476) (294)Foreign currency adjustments 47 (59) (79)Gains on issuances of stock by equity investees (23) (24) (8)Gains on sales of assets, including bottling interests (9) (20) (5)Other operating charges 85 480 330Other items 299 437 249Net change in operating assets and liabilities 430 (617) (168)

Net cash provided by operating activities 6,423 5,968 5,456

INVESTING ACTIVITIESAcquisitions and investments, principally trademarks and bottling companies (637) (267) (359)Purchases of investments and other assets (53) (46) (177)Proceeds from disposals of investments and other assets 33 161 147Purchases of property, plant and equipment (899) (755) (812)Proceeds from disposals of property, plant and equipment 88 341 87Other investing activities (28) 63 178

Net cash used in investing activities (1,496) (503) (936)

FINANCING ACTIVITIESIssuances of debt 178 3,030 1,026Payments of debt (2,460) (1,316) (1,119)Issuances of stock 230 193 98Purchases of stock for treasury (2,055) (1,739) (1,440)Dividends (2,678) (2,429) (2,166)

Net cash used in financing activities (6,785) (2,261) (3,601)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASHEQUIVALENTS (148) 141 183

CASH AND CASH EQUIVALENTSNet increase (decrease) during the year (2,006) 3,345 1,102Balance at beginning of year 6,707 3,362 2,260

Balance at end of year $ 4,701 $ 6,707 $ 3,362


B4 Appendix B Specimen Financial Statements: The Coca-Cola Company


CONSOLIDATED STATEMENTS OF SHAREOWNERS’ EQUITY

Year Ended December 31, 2005 2004 2003(In millions except per share data)

NUMBER OF COMMON SHARES OUTSTANDINGBalance at beginning of year 2,409 2,442 2,471

Stock issued to employees exercising stock options 7 5 4Purchases of stock for treasury1 (47) (38) (33)

Balance at end of year 2,369 2,409 2,442

COMMON STOCKBalance at beginning of year $ 875 $ 874 $ 873

Stock issued to employees exercising stock options 2 1 1

Balance at end of year 877 875 874

CAPITAL SURPLUSBalance at beginning of year 4,928 4,395 3,857

Stock issued to employees exercising stock options 229 175 105Tax benefit from employees’ stock option and restricted stock plans 11 13 11Stock-based compensation 324 345 422


REINVESTED EARNINGSBalance at beginning of year 29,105 26,687 24,506

Net income 4,872 4,847 4,347Dividends (per share — $1.12, $1.00 and $0.88 in 2005, 2004 and 2003, respectively) (2,678) (2,429) (2,166)


ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)Balance at beginning of year (1,348) (1,995) (3,047)

Net foreign currency translation adjustment (396) 665 921Net gain (loss) on derivatives 57 (3) (33)Net change in unrealized gain on available-for-sale securities 13 39 40Net change in minimum pension liability 5 (54) 124

Net other comprehensive income adjustments (321) 647 1,052

Balance at end of year (1,669) (1,348) (1,995)

TREASURY STOCKBalance at beginning of year (17,625) (15,871) (14,389)

Purchases of treasury stock (2,019) (1,754) (1,482)

Balance at end of year (19,644) (17,625) (15,871)

TOTAL SHAREOWNERS’ EQUITY $ 16,355 $ 15,935 $ 14,090

COMPREHENSIVE INCOMENet income $ 4,872 $ 4,847 $ 4,347Net other comprehensive income adjustments (321) 647 1,052

TOTAL COMPREHENSIVE INCOME $ 4,551 $ 5,494 $ 5,399

1 Common stock purchased from employees exercising stock options numbered 0.5 shares, 0.4 shares and 0.4 shares for the yearsended December 31, 2005, 2004 and 2003, respectively.


Time Value of Money

Appendix C

C1

Would you rather receive $1,000 today or a year from now? You should preferto receive the $1,000 today because you can invest the $1,000 and earn intereston it. As a result, you will have more than $1,000 a year from now. What thisexample illustrates is the concept of the time value of money. Everyoneprefers to receive money today rather than in the future because of the interestfactor.

S T U D Y O B J E C T I V E S

After studying this appendix, you should be able to:1 Distinguish between simple and compound interest.2 Solve for future value of a single amount.3 Solve for future value of an annuity.4 Identify the variables fundamental to solving present value

problems.5 Solve for present value of a single amount.6 Solve for present value of an annuity.7 Compute the present value of notes and bonds.8 Use a financial calculator to solve time value of money problems.

THE NATURE OF INTERESTInterest is payment for the use of another person’s money. It is the difference be-tween the amount borrowed or invested (called the principal) and the amount re-paid or collected.The amount of interest to be paid or collected is usually stated asa rate over a specific period of time. The rate of interest is generally stated as anannual rate.

The amount of interest involved in any financing transaction is based on threeelements:

1. Principal (p): The original amount borrowed or invested.2. Interest Rate (i): An annual percentage of the principal.3. Time (n): The number of years that the principal is borrowed or invested.

Simple InterestSimple interest is computed on the principal amount only. It is the returnon the principal for one period. Simple interest is usually expressed asshown in Illustration C-1 on the next page.

Distinguish between simple andcompound interest.

S T U D Y O B J E C T I V E 1

C2 Appendix C Time Value of Money

Interest � � �

For example, if you borrowed $5,000 for 2 years at a simple interest rate of 12%annually, you would pay $1,200 in total interest computed as follows:

Interest � p � i � n� $5,000 � .12 � 2� $1,200

Timen

Ratei

Principalp

Illustration C-1Interest computation

Compound InterestCompound interest is computed on principal and on any interest earned that hasnot been paid or withdrawn. It is the return on the principal for two or more timeperiods. Compounding computes interest not only on the principal but also on theinterest earned to date on that principal, assuming the interest is left on deposit.

To illustrate the difference between simple and compound interest, assumethat you deposit $1,000 in Bank Two, where it will earn simple interest of 9% peryear, and you deposit another $1,000 in Citizens Bank, where it will earn com-pound interest of 9% per year compounded annually. Also assume that in bothcases you will not withdraw any interest until three years from the date of deposit.Illustration C-2 shows the computation of interest you will receive and the accu-mulated year-end balances.

Illustration C-2Simple versus compound interest

Note in Illustration C-2 that simple interest uses the initial principal of $1,000to compute the interest in all three years. Compound interest uses the accumu-lated balance (principal plus interest to date) at each year-end to compute inter-est in the succeeding year—which explains why your compound interest accountis larger.

Obviously, if you had a choice between investing your money at simple interestor at compound interest, you would choose compound interest, all other things—especially risk—being equal. In the example, compounding provides $25.03 of ad-ditional interest income. For practical purposes, compounding assumes that unpaidinterest earned becomes a part of the principal, and the accumulated balance at the

Simple InterestCalculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

$1,000.00 × 9%

$1,000.00 × 9%

$

$

90.00

90.00

90.00

270.00

$1,090.00

$1,180.00

$1,270.00

$25.03Difference

SimpleInterest

AccumulatedYear-endBalance

Bank Two

Compound InterestCalculation

Year 1

Year 2

Year 3

$1,000.00 × 9%

$1,090.00 × 9%

$1,188.10 × 9%

$

$

90.00

98.10

106.93

295.03

$1,090.00

$1,188.10

$1,295.03

CompoundInterest

AccumulatedYear-endBalance

Citizens Bank

Future Value of a Single Amount C3

SECTION 1 Future Value Concepts

FUTURE VALUE OF A SINGLE AMOUNT

Illustration C-4Time diagram

FV � p � (1 � i )nIllustration C-3Formula for future value

where:

FV � future value of a single amountp � principal (or present value)i � interest rate for one period

n � number of periods

The $1,295.03 is computed as follows.

FV � p � (1 � i)n

� $1,000 � (1 � i)3

� $1,000 � 1.29503� $1,295.03

The 1.29503 is computed by multiplying (1.09 � 1.09 � 1.09). The amounts in thisexample can be depicted in the following time diagram.

The future value of a single amount is the value at a future date of agiven amount invested assuming compound interest. For example, inIllustration C-2, $1,295.03 is the future value of the $1,000 at the end ofthree years. The $1,295.03 could be determined more easily by using thefollowing formula.

end of each year becomes the new principal on which interest is earned during thenext year.

Illustration C-2 indicates that you should invest your money at the bank thatcompounds interest annually. Most business situations use compound interest.Simple interest is generally applicable only to short-term situations of one yearor less.

Present Value (p)

0$1,000

1 2 3$1,295.03

i = 9% FutureValue

n = 3 years

Solve for future value of a singleamount.


In Table 1, n is the number of compounding periods, the percentages are the peri-odic interest rates, and the five-digit decimal numbers in the respective columns arethe future value of 1 factors. In using Table 1, the principal amount is multiplied bythe future value factor for the specified number of periods and interest rate. For ex-ample, the future value factor for two periods at 9% is 1.18810. Multiplying thisfactor by $1,000 equals $1,188.10, which is the accumulated balance at the end ofyear 2 in the Citizens Bank example in Illustration C-2.The $1,295.03 accumulatedbalance at the end of the third year can be calculated from Table 1 by multiplyingthe future value factor for three periods (1.29503) by the $1,000.

The following demonstration problem illustrates how to use Table 1.


TABLE 1Future Value of 1

(n)Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 1.04000 1.05000 1.06000 1.08000 1.09000 1.10000 1.11000 1.12000 1.150002 1.08160 1.10250 1.12360 1.16640 1.18810 1.21000 1.23210 1.25440 1.322503 1.12486 1.15763 1.19102 1.25971 1.29503 1.33100 1.36763 1.40493 1.520884 1.16986 1.21551 1.26248 1.36049 1.41158 1.46410 1.51807 1.57352 1.749015 1.21665 1.27628 1.33823 1.46933 1.53862 1.61051 1.68506 1.76234 2.01136

6 1.26532 1.34010 1.41852 1.58687 1.67710 1.77156 1.87041 1.97382 2.313067 1.31593 1.40710 1.50363 1.71382 1.82804 1.94872 2.07616 2.21068 2.660028 1.36857 1.47746 1.59385 1.85093 1.99256 2.14359 2.30454 2.47596 3.059029 1.42331 1.55133 1.68948 1.99900 2.17189 2.35795 2.55803 2.77308 3.51788

10 1.48024 1.62889 1.79085 2.15892 2.36736 2.59374 2.83942 3.10585 4.04556

11 1.53945 1.71034 1.89830 2.33164 2.58043 2.85312 3.15176 3.47855 4.6523912 1.60103 1.79586 2.01220 2.51817 2.81267 3.13843 3.49845 3.89598 5.3502513 1.66507 1.88565 2.13293 2.71962 3.06581 3.45227 3.88328 4.36349 6.1527914 1.73168 1.97993 2.26090 2.93719 3.34173 3.79750 4.31044 4.88711 7.0757115 1.80094 2.07893 2.39656 3.17217 3.64248 4.17725 4.78459 5.47357 8.13706

16 1.87298 2.18287 2.54035 3.42594 3.97031 4.59497 5.31089 6.13039 9.3576217 1.94790 2.29202 2.69277 3.70002 4.32763 5.05447 5.89509 6.86604 10.7612618 2.02582 2.40662 2.85434 3.99602 4.71712 5.55992 6.54355 7.68997 12.3754519 2.10685 2.52695 3.02560 4.31570 5.14166 6.11591 7.26334 8.61276 14.2317720 2.19112 2.65330 3.20714 4.66096 5.60441 6.72750 8.06231 9.64629 16.36654

Another method that can be used to compute the future value of a singleamount involves the use of a compound interest table. This table shows the futurevalue of 1 for n periods. Table 1, shown below, is such a table.

Future Value of an Annuity C5

FUTURE VALUE OF AN ANNUITYThe preceding discussion involved the accumulation of only a singleprincipal sum. Individuals and businesses frequently encounter situa-tions in which a series of equal dollar amounts are to be paid or receivedperiodically, such as loans or lease (rental) contracts. Such payments orreceipts of equal dollar amounts are referred to as annuities. The future value ofan annuity is the sum of all the payments (receipts) plus the accumulated com-pound interest on them. In computing the future value of an annuity, it is neces-sary to know (1) the interest rate, (2) the number of compounding periods, and(3) the amount of the periodic payments or receipts.

To illustrate the computation of the future value of an annuity, assume that youinvest $2,000 at the end of each year for three years at 5% interest compoundedannually. This situation is depicted in the time diagram in Illustration C-6.

Solve for future value of anannuity.


Illustration C-5Demonstration Problem—Using Table 1 for FV of 1

0$20,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

i = 6%Future

Value = ?Present Value (p)

n = 18 years

John and Mary Rich invested $20,000 in a savings account paying 6% interest at the time their son,Mike, was born. The money is to be used by Mike for his college education. On his 18th birthday, Mike withdraws the money from his savings account. How much did Mike withdraw from his account?

Answer: The future value factor from Table 1 is 2.85434 (18 periods at 6%). The future value of$20,000 earning 6% per year for 18 years is $57,086.80 ($20,000 × 2.85434).

Illustration C-6Time diagram for a three-year annuity

0 1 2 3

$2,000PresentValue $2,000 $2,000

i = 5% FutureValue = ?

n = 3 years


TABLE 2Future Value of an Annuity of 1

(n)Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.000002 2.04000 2.05000 2.06000 2.08000 2.09000 2.10000 2.11000 2.12000 2.150003 3.12160 3.15250 3.18360 3.24640 3.27810 3.31000 3.34210 3.37440 3.472504 4.24646 4.31013 4.37462 4.50611 4.57313 4.64100 4.70973 4.77933 4.993385 5.41632 5.52563 5.63709 5.86660 5.98471 6.10510 6.22780 6.35285 6.74238

6 6.63298 6.80191 6.97532 7.33592 7.52334 7.71561 7.91286 8.11519 8.753747 7.89829 8.14201 8.39384 8.92280 9.20044 9.48717 9.78327 10.08901 11.066808 9.21423 9.54911 9.89747 10.63663 11.02847 11.43589 11.85943 12.29969 13.726829 10.58280 11.02656 11.49132 12.48756 13.02104 13.57948 14.16397 14.77566 16.78584

10 12.00611 12.57789 13.18079 14.48656 15.19293 15.93743 16.72201 17.54874 20.30372

11 13.48635 14.20679 14.97164 16.64549 17.56029 18.53117 19.56143 20.65458 24.3492812 15.02581 15.91713 16.86994 18.97713 20.14072 21.38428 22.71319 24.13313 29.0016713 16.62684 17.71298 18.88214 21.49530 22.95339 24.52271 26.21164 28.02911 34.3519214 18.29191 19.59863 21.01507 24.21492 26.01919 27.97498 30.09492 32.39260 40.5047115 20.02359 21.57856 23.27597 27.15211 29.36092 31.77248 34.40536 37.27972 47.58041

16 21.82453 23.65749 25.67253 30.32428 33.00340 35.94973 39.18995 42.75328 55.7174717 23.69751 25.84037 28.21288 33.75023 36.97351 40.54470 44.50084 48.88367 65.0750918 25.64541 28.13238 30.90565 37.45024 41.30134 45.59917 50.39593 55.74972 75.8363619 27.67123 30.53900 33.75999 41.44626 46.01846 51.15909 56.93949 63.43968 88.2118120 29.77808 33.06595 36.78559 45.76196 51.16012 57.27500 64.20283 72.05244 102.44358

Illustration C-7Future value of periodic payments

Year Amount Future Value of FutureInvested Invested � 1 Factor at 5% � Value

1 $2,000 � 1.10250 � $2,2052 $2,000 � 1.05000 � 2,1003 $2,000 � 1.00000 � 2,000

3.15250 $6,305

As can be seen in Illustration C-6, the $2,000 invested at the end of year 1 willearn interest for two years (years 2 and 3), and the $2,000 invested at the end ofyear 2 will earn interest for one year (year 3). However, the last $2,000 investment(made at the end of year 3) will not earn any interest.The future value of these pe-riodic payments could be computed using the future value factors from Table 1 asshown in Illustration C-7.

The first $2,000 investment is multiplied by the future value factor for two periods(1.1025) because two years’ interest will accumulate on it (in years 2 and 3). Thesecond $2,000 investment will earn only one year’s interest (in year 3) and there-fore is multiplied by the future value factor for one year (1.0500). The final $2,000investment is made at the end of the third year and will not earn any interest.Consequently, the future value of the last $2,000 invested is only $2,000 since itdoes not accumulate any interest.

This method of calculation is required when the periodic payments or receiptsare not equal in each period. However, when the periodic payments (receipts) arethe same in each period, the future value can be computed by using a future valueof an annuity of 1 table. Table 2, shown below, is such a table.

Present Value Variables C7

Illustration C-8Demonstration Problem—Using Table 2 for FV of anannuity of 1

0 1 2 3 4

$25,000PresentValue $25,000 $25,000 $25,000

i = 6% FutureValue = ?

n = 4 years

Henning Printing Company knows that in four years it must replace one of its existing printingpresses with a new one. To insure that some funds are available to replace the machine in4 years, the company is depositing $25,000 in a savings account at the end of each of thenext four years (4 deposits in total). The savings account will earn 6% interest compoundedannually. How much will be in the savings account at the end of 4 years when the newprinting press is to be purchased?

Answer: The future value factor from Table 2 is 4.37462 (4 periods at 6%). The future value of$25,000 invested at the end of each year for 4 years at 6% interest is $109,365.50($25,000 × 4.37462).

Table 2 shows the future value of 1 to be received periodically for a given numberof periods. You can see from Table 2 that the future value of an annuity of 1 factorfor three periods at 5% is 3.15250. The future value factor is the total of the threeindividual future value factors as shown in Illustration C-8. Multiplying thisamount by the annual investment of $2,000 produces a future value of $6,305.

The demonstration problem in Illustration C-8 illustrates how to use Table 2.

SECTION 2 Present Value Concepts

PRESENT VALUE VARIABLESThe present value is the value now of a given amount to be paid or re-ceived in the future, assuming compound interest. The present value isbased on three variables: (1) the dollar amount to be received (futureamount), (2) the length of time until the amount is received (number ofperiods), and (3) the interest rate (the discount rate). The process of determiningthe present value is referred to as discounting the future amount.

In this textbook, we use present value computations in measuring severalitems. For example, Chapter 11 computed the present value of the principal and in-terest payments to determine the market price of a bond. In addition, determiningthe amount to be reported for notes payable involves present value computations.

Identify the variables fundamentalto solving present value problems.


To illustrate present value, assume that you want to invest a sum of moneythat will yield $1,000 at the end of one year.What amount would you needto invest today to have $1,000 one year from now? Illustration C-9 showsthe formula for calculating present value.


PRESENT VALUE OF A SINGLE AMOUNT

Present Value � Future Value � (1 � i )nIllustration C-9Formula for present value

Thus, if you want a 10% rate of return, you would compute the present value of$1,000 for one year as follows:

PV � FV � (1 � i)n

� $1,000 � (1 � .10)1

PV � $1,000 � 1.10PV � $909.09

We know the future amount ($1,000), the discount rate (10%), and thenumber of periods (one). These variables are depicted in the time diagram inIllustration C-10.

Illustration C-10Finding present value if dis-counted for one period

i = 10%

n = 1 year

PresentValue (?)

$909.09

FutureValue

$1,000

If you receive the single amount of $1,000 in two years, discounted at10% [PV � $1,000 � (1 � .10)2], the present value of your $1,000 is $826.45[($1,000 � 1.21), depicted as shown in Illustration C-11 below.

Illustration C-11Finding present value if discounted for two periods

You also could find the present value of your amount through tables that showthe present value of 1 for n periods. In Table 3, on the next page, n (represented in

i = 10%

1

PresentValue (?)

0

FutureValue

2n = 2 years$826.45 $1,000

Solve for present value of a singleamount.


Present Value of a Single Amount C9

For example, the present value factor for one period at a discount rate of 10%is .90909, which equals the $909.09 ($1,000 � .90909) computed in Illustration C-10.For two periods at a discount rate of 10%, the present value factor is .82645, whichequals the $826.45 ($1,000 � .82645) computed previously.

Note that a higher discount rate produces a smaller present value. For example,using a 15% discount rate, the present value of $1,000 due one year from now is$869.57, versus $909.09 at 10%. Also note that the further removed from the pres-ent the future value is, the smaller the present value. For example, using the samediscount rate of 10%, the present value of $1,000 due in five years is $620.92, ver-sus the present value of $1,000 due in one year, which is $909.09.

The two demonstration problems on the next page (Illustrations C-12, C-13)illustrate how to use Table 3.

TABLE 3Present Value of 1

(n)Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .92593 .91743 .90909 .90090 .89286 .869572 .92456 .90703 .89000 .85734 .84168 .82645 .81162 .79719 .756143 .88900 .86384 .83962 .79383 .77218 .75132 .73119 .71178 .657524 .85480 .82270 .79209 .73503 .70843 .68301 .65873 .63552 .571755 .82193 .78353 .74726 .68058 .64993 .62092 .59345 .56743 .49718

6 .79031 .74622 .70496 .63017 .59627 .56447 .53464 .50663 .432337 .75992 .71068 .66506 .58349 .54703 .51316 .48166 .45235 .375948 .73069 .67684 .62741 .54027 .50187 .46651 .43393 .40388 .326909 .70259 .64461 .59190 .50025 .46043 .42410 .39092 .36061 .28426

10 .67556 .61391 .55839 .46319 .42241 .38554 .35218 .32197 .24719

11 .64958 .58468 .52679 .42888 .38753 .35049 .31728 .28748 .2149412 .62460 .55684 .49697 .39711 .35554 .31863 .28584 .25668 .1869113 .60057 .53032 .46884 .36770 .32618 .28966 .25751 .22917 .1625314 .57748 .50507 .44230 .34046 .29925 .26333 .23199 .20462 .1413315 .55526 .48102 .41727 .31524 .27454 .23939 .20900 .18270 .12289

16 .53391 .45811 .39365 .29189 .25187 .21763 .18829 .16312 .1068717 .51337 .43630 .37136 .27027 .23107 .19785 .16963 .14564 .0929318 .49363 .41552 .35034 .25025 .21199 .17986 .15282 .13004 .0808119 .47464 .39573 .33051 .23171 .19449 .16351 .13768 .11611 .0702720 .45639 .37689 .31180 .21455 .17843 .14864 .12403 .10367 .06110

the table’s rows) is the number of discounting periods involved. The percentages(represented in the table’s columns) are the periodic interest rates or discountrates. The five-digit decimal numbers in the intersections of the rows and columnsare called the present value of 1 factors.

When using Table 3 to determine present value, you multiply the future valueby the present value factor specified at the intersection of the number of periodsand the discount rate.


Illustration C-13Demonstration problem—Using Table 3 for PV of 1

PRESENT VALUE OF AN ANNUITYThe preceding discussion involved the discounting of only a single futureamount. Businesses and individuals frequently engage in transactions inwhich a series of equal dollar amounts are to be received or paid periodi-cally. Examples of a series of periodic receipts or payments are loan

agreements, installment sales, mortgage notes, lease (rental) contracts, and pensionobligations.These periodic receipts or payments are annuities.

The present value of an annuity is the value now of a series of future receiptsor payments, discounted assuming compound interest. In computing the presentvalue of an annuity, you need to know: (1) the discount rate, (2) the number of dis-count periods, and (3) the amount of the periodic receipts or payments.

To illustrate how to compute the present value of an annuity, assume that youwill receive $1,000 cash annually for three years at a time when the discount rate is10%. Illustration C-14 depicts this situation, and Illustration C-15 shows the com-putation of its present value.

Solve for present value of anannuity.


Illustration C-12Demonstration problem—Using Table 3 for PV of 1

i = 8%

2

PV = ?

Now

$10,000

3 years1

Suppose you have a winning lottery ticket and the state gives you theoption of taking $10,000 three years from now or taking the presentvalue of $10,000 now. The state uses an 8% rate in discounting. Howmuch will you receive if you accept your winnings now?

Answer: The present value factor from Table 3 is .79383(3 periods at 8%). The present value of $10,000 to be received in3 years discounted at 8% is $7,938.30 ($10,000 × .79383).

n = 3

i = 9%

3

PV = ?

Now

$5,000

4 years1

Determine the amount you must deposit now in your SUPERsavings account, paying 9% interest, in order to accumulate $5,000for a down payment 4 years from now on a new Chevy Tahoe.

Answer: The present value factor from Table 3 is .70843(4 periods at 9%). The present value of $5,000 to be received in4 years discounted at 9% is $3,542.15 ($5,000 × .70843).

2n = 4

This method of calculation is required when the periodic cash flows are notuniform in each period. However, when the future receipts are the same in eachperiod, there are two other ways to compute present value. First, you can multiplythe annual cash flow by the sum of the three present value factors. In the previousexample, $1,000 � 2.48686 equals $2,486.86. The second method is to use annuitytables.As illustrated in Table 4 below, these tables show the present value of 1 to bereceived periodically for a given number of periods.

Present Value of an Annuity C11

Present Value of 1Future Amount � Factor at 10% � Present Value

$1,000 (one year away) .90909 $ 909.091,000 (two years away) .82645 826.451,000 (three years away) .75132 751.32

2.48686 $2,486.86

Illustration C-14Time diagram for a three-year annuity

Illustration C-15Present value of a series offuture amounts computation

i = 10%

2Now 3 years

PV = ? $1,000 $1,000$1,000

1n = 3

TABLE 4Present Value of an Annuity of 1

(n)Periods 4% 5% 6% 8% 9% 10% 11% 12% 15%

1 .96154 .95238 .94340 .92593 .91743 .90909 .90090 .89286 .869572 1.88609 1.85941 1.83339 1.78326 1.75911 1.73554 1.71252 1.69005 1.625713 2.77509 2.72325 2.67301 2.57710 2.53130 2.48685 2.44371 2.40183 2.283234 3.62990 3.54595 3.46511 3.31213 3.23972 3.16986 3.10245 3.03735 2.854985 4.45182 4.32948 4.21236 3.99271 3.88965 3.79079 3.69590 3.60478 3.35216

6 5.24214 5.07569 4.91732 4.62288 4.48592 4.35526 4.23054 4.11141 3.784487 6.00205 5.78637 5.58238 5.20637 5.03295 4.86842 4.71220 4.56376 4.160428 6.73274 6.46321 6.20979 5.74664 5.53482 5.33493 5.14612 4.96764 4.487329 7.43533 7.10782 6.80169 6.24689 5.99525 5.75902 5.53705 5.32825 4.77158

10 8.11090 7.72173 7.36009 6.71008 6.41766 6.14457 5.88923 5.65022 5.01877

11 8.76048 8.30641 7.88687 7.13896 6.80519 6.49506 6.20652 5.93770 5.2337112 9.38507 8.86325 8.38384 7.53608 7.16073 6.81369 6.49236 6.19437 5.4206213 9.98565 9.39357 8.85268 7.90378 7.48690 7.10336 6.74987 6.42355 5.5831514 10.56312 9.89864 9.29498 8.24424 7.78615 7.36669 6.98187 6.62817 5.7244815 11.11839 10.37966 9.71225 8.55948 8.06069 7.60608 7.19087 6.81086 5.84737

16 11.65230 10.83777 10.10590 8.85137 8.31256 7.82371 7.37916 6.97399 5.9542417 12.16567 11.27407 10.47726 9.12164 8.54363 8.02155 7.54879 7.11963 6.0471618 12.65930 11.68959 10.82760 9.37189 8.75563 8.20141 7.70162 7.24967 6.1279719 13.13394 12.08532 11.15812 9.60360 8.95012 8.36492 7.83929 7.36578 6.1982320 13.59033 12.46221 11.46992 9.81815 9.12855 8.51356 7.96333 7.46944 6.25933

Table 4 shows that the present value of an annuity of 1 factor for three periodsat 10% is 2.48685.1 (This present value factor is the total of the three individualpresent value factors, as shown in Illustration C-15.) Applying this amount to theannual cash flow of $1,000 produces a present value of $2,486.85.

The following demonstration problem (Illustration C-16) illustrates how to useTable 4.


1The difference of .00001 between 2.48686 and 2.48685 is due to rounding.

Illustration C-16Demonstration problem—Using Table 4 for PV of anannuity of 1

TIME PERIODS AND DISCOUNTINGIn the preceding calculations, the discounting was done on an annual basis using anannual interest rate. Discounting may also be done over shorter periods of timesuch as monthly, quarterly, or semiannually.

When the time frame is less than one year, you need to convert the annualinterest rate to the applicable time frame.Assume, for example, that the investor inIllustration C-14 received $500 semiannually for three years instead of $1,000 an-nually. In this case, the number of periods becomes six (3 � 2), the discount rate is5% (10% � 2), the present value factor from Table 4 is 5.07569, and the presentvalue of the future cash flows is $2,537.85 (5.07569 � $500). This amount is slightlyhigher than the $2,486.86 computed in Illustration C-15 because interest is paidtwice during the same year; therefore interest is earned on the first half year’sinterest.

i = 12%

4

PV = ?

Now

$6,000

5 years1

Kildare Company has just signed a capitalizable lease contract for equip-ment that requires rental payments of $6,000 each, to be paid at the endof each of the next 5 years. The appropriate discount rate is 12%. Whatis the present value of the rental payments—that is, the amount used tocapitalize the leased equipment?

Answer: The present value factor from Table 4 is 3.60478(5 periods at 12%). The present value of 5 payments of $6,000 eachdiscounted at 12% is $21,628.68 ($6,000 × 3.60478).

$6,000 $6,000

2 3

$6,000 $6,000

n = 5

COMPUTING THE PRESENT VALUEOF A LONG-TERM NOTE OR BOND

The present value (or market price) of a long-term note or bond is a func-tion of three variables: (1) the payment amounts, (2) the length of time un-til the amounts are paid, and (3) the discount rate. Our illustration uses afive-year bond issue.

Compute the present value ofnotes and bonds.


Computing the Present Value of a Long-Term Note or Bond C13

The first variable—dollars to be paid—is made up of two elements: (1) a seriesof interest payments (an annuity), and (2) the principal amount (a single sum). Tocompute the present value of the bond, we must discount both the interest pay-ments and the principal amount—two different computations. The time diagramsfor a bond due in five years are shown in Illustration C-17.

When the investor’s market interest rate is equal to the bond’s contractual in-terest rate, the present value of the bonds will equal the face value of the bonds. Toillustrate, assume a bond issue of 10%, five-year bonds with a face value of$100,000 with interest payable semiannually on January 1 and July 1. If the discountrate is the same as the contractual rate, the bonds will sell at face value. In this case,the investor will receive the following: (1) $100,000 at maturity, and (2) a series often $5,000 interest payments [($100,000 � 10%) � 2] over the term of the bonds.The length of time is expressed in terms of interest periods—in this case—10,and the discount rate per interest period, 5%. The following time diagram(Illustration C-18) depicts the variables involved in this discounting situation.

Illustration C-17Present value of a bondtime diagram

Illustration C-18Time diagram for presentvalue of a 10%, five-yearbond paying interest semiannually

Interest Rate (i)

1 yr.

PresentValue (?)

Now

PrincipalAmount

5 yr.

Diagramfor

Principal2 yr. 3 yr. 4 yr.

Interest

1 yr.

PresentValue (?)

Now 5 yr.

Diagramfor

Interest2 yr. 3 yr. 4 yr.

Interest Rate (i)Interest Interest Interest Interest

n = 5

n = 5

i = 5%

1

PresentValue(?)

Now

PrincipalAmount$100,000

10

Diagramfor

Principal5 6

1

PresentValue(?)

Now 10

Diagramfor

Interest5 6

i = 5%$5,000

2

2

3

3

4

4

7

7

8

8

9

9

$5,000 $5,000 $5,000 $5,000$5,000 $5,000 $5,000 $5,000

n = 10

n = 10

$5,000

InterestPayments

Illustration C-19 shows the computation of the present value of these bonds.


10% Contractual Rate—10% Discount Rate

Present value of principal to be received at maturity$100,000 � PV of 1 due in 10 periods at 5%$100,000 � .61391 (Table 3) $ 61,391

Present value of interest to be received periodicallyover the term of the bonds

$5,000 � PV of 1 due periodically for 10 periods at 5%$5,000 � 7.72173 (Table 4) 38,609*

Present value of bonds $100,000

*Rounded


Present value of principal to be received at maturity$100,000 � .55839 (Table 3) $55,839


$5,000 � 7.36009 (Table 4) 36,800



Present value of principal to be received at maturity$100,000 � .67556 (Table 3) $ 67,556


$5,000 � 8.11090 (Table 4) 40,555


Now assume that the investor’s required rate of return is 12%, not 10%.The fu-ture amounts are again $100,000 and $5,000, respectively, but now a discount rateof 6% (12% � 2) must be used. The present value of the bonds is $92,639, as com-puted in Illustration C-20.

Conversely, if the discount rate is 8% and the contractual rate is 10%, the pres-ent value of the bonds is $108,111, computed as shown in Illustration C-21.

The above discussion relies on present value tables in solving present valueproblems. Many people use spreadsheets such as Excel or Financial calculators(some even on websites) to compute present values, without the use of tables.Many calculators, especially financial calculators, have present value (PV)functions that allow you to calculate present values by merely inputting theproper amount, discount rate, and periods, and pressing the PV key. The nextsection illustrates how to use a financial calculator in various business situations.

Illustration C-19Present value of principaland interest—face value

Illustration C-20Present value of principaland interest—discount

Illustration C-21Present value of principaland interest—premium

Using Financial Calculators—Present Value of a Single Sum C15

SECTION 3 Using Financial Calculators

Business professionals, once they have mastered the underlying conceptsin sections 1 and 2, often use a financial (business) calculator to solve timevalue of money problems. In many cases, they must use calculators if in-terest rates or time periods do not correspond with the information pro-vided in the compound interest tables.

To use financial calculators, you enter the time value of money variables intothe calculator. Illustration C-22 shows the five most common keys used to solvetime value of money problems.2

Use a financial calculator to solvetime value of money problems.


Illustration C-22Financial calculator keys

N I PV PMT FV

where

N � number of periods

I � interest rate per period (some calculators use I/YR or i)

PV � present value (occurs at the beginning of the first period)

PMT � payment (all payments are equal, and none are skipped)

FV � future value (occurs at the end of the last period)

In solving time value of money problems in this appendix, you will generally begiven three of four variables and will have to solve for the remaining variable. Thefifth key (the key not used) is given a value of zero to ensure that this variable isnot used in the computation.

PRESENT VALUE OF A SINGLE SUMTo illustrate how to solve a present value problem using a financial calculator, assumethat you want to know the present value of $84,253 to be received in five years, dis-counted at 11% compounded annually. Illustration C-23 pictures this problem.

2On many calculators, these keys are actual buttons on the face of the calculator; on others theyappear on the display after the user accesses a present value menu.

Illustration C-23Calculator solution forpresent value of a single sum

? 0 84,253

–50,000

N

Inputs: 5

Answer:

11

I PV PMT FV

The diagram shows you the information (inputs) to enter into the calculator:N � 5, I � 11, PMT � 0, and FV � 84,253. You then press PV for the answer:�$50,000. As indicated, the PMT key was given a value of zero because a series ofpayments did not occur in this problem.

Plus and MinusThe use of plus and minus signs in time value of money problems with a financialcalculator can be confusing. Most financial calculators are programmed so that thepositive and negative cash flows in any problem offset each other. In the presentvalue problem, we identified the $84,253 future value initial investment as a positive(inflow); the answer �$50,000 was shown as a negative amount, reflecting a cashoutflow. If the 84,253 were entered as a negative, then the final answer would havebeen reported as a positive 50,000.

Hopefully, the sign convention will not cause confusion. If you understandwhat is required in a problem, you should be able to interpret a positive or negativeamount in determining the solution to a problem.

Compounding PeriodsIn the problem on page C15, we assumed that compounding occurs once a year.Some financial calculators have a default setting, which assumes that compoundingoccurs 12 times a year. You must determine what default period has been pro-grammed into your calculator and change it as necessary to arrive at the propercompounding period.

RoundingMost financial calculators store and calculate using 12 decimal places. As a result,because compound interest tables generally have factors only up to 5 decimalplaces, a slight difference in the final answer can result. In most time value ofmoney problems, the final answer will not include more than two decimal points.


PRESENT VALUE OF AN ANNUITYTo illustrate how to solve a present value of an annuity problem using a financialcalculator, assume that you are asked to determine the present value of rental re-ceipts of $6,000 each to be received at the end of each of the next five years, whendiscounted at 12%, as pictured in Illustration C-24.

Illustration C-24Calculator solution forpresent value of an annuity

N

Inputs: 5 12 ? 6,000 0

Answer: –21,628.66

I PV PMT FV

In this case, you enter N � 5, I � 12, PMT � 6,000, FV � 0, and then press PV toarrive at the answer of $21, 628.66.

USEFUL APPLICATIONS OF THE FINANCIAL CALCULATOR

With a financial calculator you can solve for any interest rate or for any numberof periods in a time value of money problem. Here are some examples of theseapplications.

Auto LoanAssume you are financing a car with a three-year loan. The loan has a 9.5% nomi-nal annual interest rate, compounded monthly. The price of the car is $6,000, andyou want to determine the monthly payments, assuming that the payments startone month after the purchase. This problem is pictured in Illustration C-25.

Summary of Study Objectives C17

To solve this problem, you enter N � 36 (12 � 3), I � 9.5, PV � 6,000, FV � 0, andthen press PMT.You will find that the monthly payments will be $192.20. Note thatthe payment key is usually programmed for 12 payments per year. Thus, you mustchange the default (compounding period) if the payments are other than monthly.

Mortgage Loan AmountLet’s say you are evaluating financing options for a loan on a house. You decidethat the maximum mortgage payment you can afford is $700 per month.The annualinterest rate is 8.4%. If you get a mortgage that requires you to make monthly pay-ments over a 15-year period, what is the maximum purchase price you can afford?Illustration C-26 depicts this problem.

Illustration C-25Calculator solution for autoloan payments

Illustration C-26Calculator solution formortgage amount

N

Inputs: 36 9.5 6,000 ? 0

Answer: –192.20

I PV PMT FV

N

Inputs: 180 8.4 ? –700 0

Answer: 71,509.81

I PV PMT FV

You enter N � 180 (12 � 15 years), I � 8.4, PMT � �700, FV � 0, and press PV.With the payment-per-year key set at 12, you find a present value of $71,509.81—the maximum house price you can afford, given that you want to keep your mort-gage payments at $700. Note that by changing any of the variables, you can quicklyconduct “what-if” analyses for different situations.

SUMMARY OF STUDY OBJECTIVES1. Distinguish between simple and compound interest.

Simple interest is computed on the principal only, whereascompound interest is computed on the principal and anyinterest earned that has not been withdrawn.

2. Solve for future value of a single amount. Prepare atime diagram of the problem. Identify the principalamount, the number of compounding periods, and the in-

terest rate. Using the future value of 1 table, multiply theprincipal amount by the future value factor specified atthe intersection of the number of periods and the interestrate.

3. Solve for future value of an annuity. Prepare a time di-agram of the problem. Identify the amount of the periodicpayments, the number of compounding periods, and the


GLOSSARYAnnuity A series of equal dollar amounts to be paid or

received periodically. (p. C5, C10)

Compound interest The interest computed on the principaland any interest earned that has not been paid or received.(p. C2)

Discounting the future amount(s) The process of determin-ing present value. (p. C7)

Future value of a single amount The value at a future dateof a given amount invested assuming compound interest.(p. C3)

Future value of an annuity The sum of all the payments orreceipts plus the accumulated compound interest on them.(p. C5)

Interest Payment for the use of another’s money. (p. C1)

Present value The value now of a given amount to be investedor received in the future assuming compound interest.(p. C7)

Present value of an annuity A series of future receipts orpayments discounted to their value now assuming com-pound interest. (p. C10)

Principal The amount borrowed or invested. (p. C1)

Simple interest The interest computed on the principal only.(p. C1)

interest rate. Using the future value of an annuity of 1 table,multiply the amount of the payments by the future valuefactor specified at the intersection of the number of periodsand the interest rate.

4. Identify the variables fundamental to solving presentvalue problems. The following three variables are funda-mental to solving present value problems: (1) the futureamount, (2) the number of periods, and (3) the interest rate(the discount rate).

5. Solve for present value of a single amount. Prepare atime diagram of the problem. Identify the future amount,the number of discounting periods, and the discount (inter-est) rate. Using the present value of 1 table, multiply the fu-ture amount by the present value factor specified at the in-tersection of the number of periods and the discount rate.

6. Solve for present value of an annuity. Prepare a timediagram of the problem. Identify the future amounts (an-nuities), the number of discounting periods, and the dis-count (interest) rate. Using the present value of an annuityof 1 table, multiply the amount of the annuity by the pres-ent value factor specified at the intersection of the numberof periods and the interest rate.

7. Compute the present value of notes and bonds. Todetermine the present value of the principal amount:Multiply the principal amount (a single future amount) bythe present value factor (from the present value of 1 table)intersecting at the number of periods (number of interestpayments) and the discount rate. To determine the presentvalue of the series of interest payments: Multiply theamount of the interest payment by the present value factor(from the present value of an annuity of 1 table) intersect-ing at the number of periods (number of interest pay-ments) and the discount rate. Add the present value of theprincipal amount to the present value of the interest pay-ments to arrive at the present value of the note or bond.

8. Use a financial calculator to solve time value of moneyproblems. Financial calculators can be used to solve thesame and additional problems as those solved with timevalue of money tables. One enters into the financial calcu-lator the amounts for all of the known elements of a timevalue of money problem (periods, interest rate, payments,future or present value) and solves for the unknown element.Particularly useful situations involve interest rates andcompounding periods not presented in the tables.

BRIEF EXERCISESUse tables to solve Brief Exercises 1-23.

BEC-1 Russ Holub invested $4,000 at 5% annual interest, and left the money invested withoutwithdrawing any of the interest for 10 years. At the end of the 10 years, Russ withdrew the accu-mulated amount of money.

(a) What amount did Russ withdraw assuming the investment earns simple interest?(b) What amount did Russ withdraw assuming the investment earns interest compound annually?

BEC-2 For each of the following cases, indicate (1) to what interest rate columns and (2) towhat number of periods you would refer in looking up the future value factor.

1. In Table 1 (future value of 1):

Annual Number ofRate Years Invested Compounded

(a) 8% 5 Annually(b) 5% 3 Semiannually

Compute the future value ofa single amount.

(SO 2)

Use future value tables.

(SO 2, 3)

2. In Table 2 (future value of an annuity of 1):

Brief Exercises C19

Annual Number ofRate Years Invested Compounded

(a) 5% 10 Annually(b) 4% 6 Semiannually

BEC-3 Racine Company signed a lease for an office building for a period of 10 years. Under thelease agreement, a security deposit of $10,000 is made. The deposit will be returned at the expi-ration of the lease with interest compounded at 4% per year. What amount will Racine receiveat the time the lease expires?

BEC-4 Chaffee Company issued $1,000,000, 10-year bonds and agreed to make annual sinkingfund deposits of $75,000. The deposits are made at the end of each year into an account paying6% annual interest. What amount will be in the sinking fund at the end of 10 years?

BEC-5 Wayne and Brenda Anderson invested $5,000 in a savings account paying 5% com-pound annual interest when their daughter, Sue, was born.They also deposited $1,000 on each ofher birthdays until she was 18 (including her 18th birthday). How much will be in the savings ac-count on her 18th birthday (after the last deposit)?

BEC-6 Ty Ngu borrowed $20,000 on July 1, 2002.This amount plus accrued interest at 6% com-pounded annually is to be repaid on July 1, 2008. How much will Ty have to repay on July 1, 2008?

BEC-7 For each of the following cases, indicate (a) to what interest rate columns and (b) towhat number of periods you would refer in looking up the discount rate.

1. In Table 3 (present value of 1):

Number of DiscountsAnnual Rate Years Involved Per Year

(a) 12% 6 Annually(b) 10% 15 Annually(c) 8% 10 Semiannually

2. In Table 4 (present value of an annuity of 1):

Number of Number of Frequency ofAnnual Rate Years Involved Payments Involved Payments

(a) 8% 20 20 Annually(b) 10% 5 5 Annually(c) 12% 4 8 Semiannually

BEC-8 (a) What is the present value of $20,000 due 8 periods from now, discounted at 8%?(b) What is the present value of $20,000 to be received at the end of each of 6 periods, discountedat 9%?

BEC-9 Gonzalez Company is considering an investment that will return a lump sum of$500,000 5 years from now. What amount should Gonzalez Company pay for this investment inorder to earn a 10% return?

BEC-10 Lasorda Company earns 9% on an investment that will return $875,000 8 yearsfrom now. What is the amount Lasorda should invest now in order to earn this rate of return?

BEC-11 Bosco Company is considering investing in an annuity contract that will return $30,000annually at the end of each year for 15 years. What amount should Bosco Company pay for thisinvestment if it earns a 6% return?

BEC-12 Modine Enterprises earns 11% on an investment that pays back $120,000 at the end ofeach of the next 4 years. What is the amount Modine Enterprises invested to earn the 11% rateof return?

BEC-13 Midwest Railroad Co. is about to issue $100,000 of 10-year bonds paying a 10% inter-est rate, with interest payable semiannually. The discount rate for such securities is 8%. Howmuch can Midwest expect to receive from the sale of these bonds?


(SO 2)

Compute the future value of anannuity.

(SO 3)

Compute the future value ofa single amount and of anannuity.

(SO 2, 3)


(SO 2)Use present value tables.

(SO 5, 6)

Determine present values.

(SO 5, 6)

Compute the present value of asingle-sum investment.

(SO 5)

Compute the present value of asingle-sum investment.

(SO 5)

Compute the present value ofan annuity investment.

(SO 6)

Compute the present value ofan annuity investment.

(SO 6)

Compute the present value ofbonds.

(SO 5, 6, 7)

BEC-14 Assume the same information as in BEC-13 except that the discount rate is 10% in-stead of 8%. In this case, how much can Midwest expect to receive from the sale of thesebonds?

BEC-15 Lounsbury Company receives a $50,000, 6-year note bearing interest of 8% (paid an-nually) from a customer at a time when the discount rate is 9%. What is the present value of thenote received by Lounsbury Company?

BEC-16 Hartzler Enterprises issued 8%, 8-year, $2,000,000 par value bonds that pay interestsemiannually on October 1 and April 1.The bonds are dated April 1, 2008, and are issued on thatdate. The discount rate of interest for such bonds on April 1, 2008, is 10%. What cash proceedsdid Hartzler receive from issuance of the bonds?

BEC-17 Vinny Carpino owns a garage and is contemplating purchasing a tire retreading ma-chine for $16,280.After estimating costs and revenues,Vinny projects a net cash flow from the re-treading machine of $3,000 annually for 8 years.Vinny hopes to earn a return of 11% on such in-vestments. What is the present value of the retreading operation? Should Vinny Carpinopurchase the retreading machine?

BEC-18 Rodriguez Company issues a 10%, 6-year mortgage note on January 1, 2008, to obtainfinancing for new equipment. Land is used as collateral for the note.The terms provide for semi-annual installment payments of $56,413.What were the cash proceeds received from the issuanceof the note?

BEC-19 Goltra Company is considering purchasing equipment. The equipment will producethe following cash flows: Year 1, $30,000; Year 2, $40,000; Year 3, $50,000. Goltra requires a min-imum rate of return of 12%. What is the maximum price Goltra should pay for this equipment?

BEC-20 If Maria Sanchez invests $3,152 now, she will receive $10,000 at the end of 15 years.What annual rate of interest will Maria earn on her investment? (Hint: Use Table 3.)

BEC-21 Lori Burke has been offered the opportunity of investing $42,410 now.The investmentwill earn 10% per year and at the end of that time will return Lori $100,000. How many yearsmust Lori wait to receive $100,000? (Hint: Use Table 3.)

BEC-22 Nancy Burns purchased an investment for $12,462.21. From this investment, she willreceive $1,000 annually for the next 20 years, starting one year from now. What rate of interestwill Nancy’s investment be earning for her? (Hint: Use Table 4.)

BEC-23 Betty Estes invests $7,536.08 now for a series of $1,000 annual returns, beginning oneyear from now. Betty will earn a return of 8% on the initial investment. How many annual pay-ments of $1,000 will Betty receive? (Hint: Use Table 4.)

BEC-24 Reba McEntire wishes to invest $19,000 on July 1, 2008, and have it accumulate to$49,000 by July 1, 2018.

InstructionsUse a financial calculator to determine at what exact annual rate of interest Reba must invest the$19,000.

BEC-25 On July 17, 2008, Tim McGraw borrowed $42,000 from his grandfather to open aclothing store. Starting July 17, 2009, Tim has to make 10 equal annual payments of $6,500 eachto repay the loan.

InstructionsUse a financial calculator to determine what interest rate Tim is paying.

BEC-26 As the purchaser of a new house, Patty Loveless has signed a mortgage note to paythe Memphis National Bank and Trust Co. $14,000 every 6 months for 20 years, at the end ofwhich time she will own the house. At the date the mortgage is signed the purchase price was$198,000, and Loveless made a down payment of $20,000.The first payment will be made 6 monthsafter the date the mortgage is signed.

InstructionsUsing a financial calculator, compute the exact rate of interest earned on the mortgage by thebank.


Compute the present value of anote.

(SO 5, 6, 7)


(SO 5, 6, 7)

Compute the maximum price topay for the equipment.

(SO 7)

Compute the interest rate on asingle sum.

(SO 5)Compute the number ofperiods of a single sum.

(SO 5)

Compute the interest rate on anannuity.

(SO 6)

Compute the number ofperiods of an annuity.

(SO 6)

Compute the value of amachine for purposes ofmaking a purchase decision.

(SO 7)

Compute the present value of anote.

(SO 5, 6)


(SO 5, 6, 7)

Determine interest rate.

(SO 8)


(SO 8)


(SO 8)

BEC-27 Using a financial calculator, solve for the unknowns in each of the followingsituations.

(a) On June 1, 2008, Shelley Long purchases lakefront property from her neighbor, JoeyBrenner, and agrees to pay the purchase price in seven payments of $16,000 each, the firstpayment to be payable June 1, 2009. (Assume that interest compounded at an annual rate of7.35% is implicit in the payments.) What is the purchase price of the property?

(b) On January 1, 2008, Cooke Corporation purchased 200 of the $1,000 face value, 8% coupon,10-year bonds of Howe Inc. The bonds mature on January 1, 2018, and pay interest annuallybeginning January 1, 2009. Cooke purchased the bonds to yield 10.65%. How much didCooke pay for the bonds?

BEC-28 Using a financial calculator, provide a solution to each of the following situations.

(a) Bill Schroeder owes a debt of $35,000 from the purchase of his new sport utility vehicle. Thedebt bears annual interest of 9.1% compounded monthly. Bill wishes to pay the debt and in-terest in equal monthly payments over 8 years, beginning one month hence. What equalmonthly payments will pay off the debt and interest?

(b) On January 1, 2008, Sammy Sosa offers to buy Mark Grace’s used snowmobile for $8,000,payable in five equal annual installments, which are to include 8.25% interest on the unpaidbalance and a portion of the principal. If the first payment is to be made on December 31,2008, how much will each payment be?

Brief Exercises C21

Various time value of moneysituations.

(SO 8)

Various time value of moneysituations.

(SO 8)

D1

Payroll Accounting

Appendix D

Payroll and related fringe benefits often make up a large percentage of current lia-bilities. Employee compensation is often the most significant expense that a com-pany incurs. For example, Costco recently reported total employees of 103,000 andlabor and fringe benefits costs that approximated 70% of the company’s total costof operations.

Payroll accounting involves more than paying employees’ wages. Companies arerequired by law to maintain payroll records for each employee, to file and pay payrolltaxes, and to comply with numerous state and federal tax laws related to employeecompensation. Accounting for payroll has become much more complex due to theseregulations.

After studying this appendix, you should be able to:1. Discuss the objectives of internal control for payroll.2. Compute and record the payroll for a pay period.3. Describe and record employer payroll taxes.

S T U D Y O B J E C T I V E

PAYROLL DEFINEDThe term “payroll” pertains to both salaries and wages. Managerial, administrative,and sales personnel are generally paid salaries. Salaries are often expressed interms of a specified amount per month or per year rather than an hourly rate. Storeclerks, factory employees, and manual laborers are normally paid wages.Wages arebased on a rate per hour or on a piecework basis (such as per unit of product).Frequently, people use the terms “salaries” and “wages” interchangeably.

The term “payroll” does not apply to payments made for services of profes-sionals such as certified public accountants, attorneys, and architects. Such profes-sionals are independent contractors rather than salaried employees. Payments tothem are called fees. This distinction is important because government regulationsrelating to the payment and reporting of payroll taxes apply only to employees.

INTERNAL CONTROL OF PAYROLLChapter 8 introduced internal control. As applied to payrolls, the objec-tives of internal control are (1) to safeguard company assets against unau-thorized payments of payroll and (2) to ensure the accuracy and reliabilityof the accounting records pertaining to payrolls.

Irregularities often result if internal control is lax. Methods of theft involvingpayroll include overstating hours, using unauthorized pay rates, adding fictitiousemployees to the payroll, continuing terminated employees on the payroll, and dis-tributing duplicate payroll checks. Moreover, inaccurate records will result in in-correct paychecks, financial statements, and payroll tax returns.

Discuss the objectives of internalcontrol for payroll.


Payroll activities involve four functions: hiring employees, timekeeping,preparing the payroll, and paying the payroll. For effective internal control, thecompany should assign these four functions to different departments or individuals.To illustrate these functions, we will examine the case of Academy Company andone of its employees, Michael Jordan.

Hiring EmployeesThe human resources (personnel) department is responsible for posting job open-ings, screening and interviewing applicants, and hiring employees. From a controlstandpoint, this department provides significant documentation and authorization.When an employee is hired, the human resources department prepares an author-ization form. The one used by Academy Company for Michael Jordan is shown inIllustration D-1.

D2 Appendix D Payroll Accounting

Illustration D-1Authorization form preparedby the human resources department

Human Resources

Human Resources department documents and

authorizes employment.

Hiring Employees

ACADEMY COMPANY

Employee Name

Classification

Department

LAST MIJordan,

Skilled-Level 10

Shipping

NEWHIRE

RATECHANGE

SEPARATION

APPROVALS

FIRSTMichael Starting Date

Social Security No.

Division

9/01/06

329-36-9547

Entertainment

Classification

Rate $

Clerk

10.00 per hour Bonus N/A

Salary Grade Level 10

Non-exempt x Exempt

Trans. from Temp.

New Rate $

Present Rate $

12.00 9/1/07

10.00

Other

Effective Date

Merit x Promotion Decrease

Amount $ per TypePrevious Increase Date None

ReasonResignation Discharge Retirement

FromLeave of absence to Type

Last Day Worked

BRANCH OR DEPT. MANAGER DATE DIVISION V.P. DATE

PERSONNEL DEPARTMENT

The human resources department sends the authorization form to the payrolldepartment, where it is used to place the new employee on the payroll.A chief con-cern of the human resources department is ensuring the accuracy of this form. Thereason is quite simple: One of the most common types of payroll frauds is addingfictitious employees to the payroll.

The human resources department is also responsible for authorizing changes in employment status. Specifically, they must authorize (1) changes in pay rates and(2) terminations of employment. Every authorization should be in writing, and acopy of the change in status should be sent to the payroll department. Notice inIllustration D-1 that Jordan received a pay increase of $2 per hour.

TimekeepingAnother area in which internal control is important is timekeeping. Hourly em-ployees are usually required to record time worked by “punching” a time clock.Theemployee inserts a time card into the clock, which automatically records theemployee’s arrival and departure times. Illustration D-2 shows Michael Jordan’stime card.

Internal Control of Payroll D3

In large companies, time clock procedures are often monitored by a supervisoror security guard to make sure an employee punches only his or her own card.At theend of the pay period, each employee’s supervisor approves the hours shown by sign-ing the time card.When overtime hours are involved, approval by a supervisor is usu-ally mandatory.This guards against unauthorized overtime.The approved time cardsare then sent to the payroll department. For salaried employees, a manually preparedweekly or monthly time report kept by a supervisor may be used to record timeworked.

Preparing the PayrollThe payroll department prepares the payroll on the basis of two inputs: (1) humanresources department authorizations and (2) approved time cards. Numerous cal-culations are involved in determining gross wages and payroll deductions.Therefore, a second payroll department employee, working independently, verifiesall calculated amounts, and a payroll department supervisor then approves thepayroll.The payroll department is also responsible for preparing (but not signing) pay-roll checks, maintaining payroll records, and preparing payroll tax returns.

Illustration D-2Time card

Supervisors monitor hoursworked through time cards

and time reports.

Timekeeping

EXTRA TIMENAME Michael Jordan

No. 17 1/14/08

PAY PERIOD ENDING

REGULAR TIMEA.M. 8:58

12:001:005:019:00

11:5912:59

5:008:59

12:011:015:009:00

12:001:005:008:57

11:581:005:018:001:00

INOUT

INOUT

P.M.

NO

ON

7th Day

6th Day

5th Day

4th Day

3rd Day

2nd Day

1st Day

5:009:00

TTHH

IISSSS

IIDD

EEO

UO

UTT

TOTAL 4 TOTAL 40

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

INOUT

A.M.

P.M.

NO

ON

A.M.

P.M.

NO

ON

A.M.

P.M.N

OO

N

A.M.

P.M.

NO

ON

A.M.

P.M.

NO

ON

A.M.

P.M.

NO

ON

Two (or more) employeesverify payroll amounts;supervisor approves.

Preparing the Payroll

Paying the PayrollThe treasurer’s department pays the payroll. Payment by check minimizes the riskof loss from theft, and the endorsed check provides proof of payment. For goodinternal control, payroll checks should be prenumbered, and all checks should beaccounted for. All checks must be signed by the treasurer (or a designated agent).Distribution of the payroll checks to employees should be controlled by the trea-surer’s department. Many employees have their pay credited electronically to theirbank accounts. To control these disbursements, the company provides to employ-ees receipts detailing gross pay deductions and net pay.

Occasionally companies pay the payroll in currency. In such cases it is custom-ary to have a second person count the cash in each pay envelope. The paymastershould obtain a signed receipt from the employee upon payment.


Treasurer signs anddistributes checks.

Paying the Payroll

Type of Pay Hours � Rate � Gross EarningsRegular 40 � $12 � $480Overtime 4 � 18 � 72

Total wages $552

Illustration D-3Computation of total wages

This computation assumes that Jordan receives 11⁄2 times his regularhourly rate ($12 � 1.5) for his overtime hours. Union contracts often re-quire that overtime rates be as much as twice the regular rates.

An employee’s salary is generally based on a monthly or yearly rate.The company then prorates these rates to its payroll periods (e.g., bi-weekly or monthly). Most executive and administrative positions aresalaried. Federal law does not require overtime pay for employees insuch positions.

Many companies have bonus agreements for employees. One surveyfound that over 94% of the largest U.S. manufacturing companies offer an-

nual bonuses to key executives. Bonus arrangements may be based on such factorsas increased sales or net income. Companies may pay bonuses in cash and/or bygranting employees the opportunity to acquire shares of company stock at favor-able prices (called stock option plans).

E T H I C S N O T E

Bonuses often reward out-standing individual per-

formance, but successful corpo-rations also need considerableteamwork. A challenge is tomotivate individuals while pre-venting an unethical employeefrom taking another’s idea forhis or her own advantage.

DETERMINING THE PAYROLLDetermining the payroll involves computing three amounts: (1) grossearnings, (2) payroll deductions, and (3) net pay.

Gross EarningsGross earnings is the total compensation earned by an employee. It consists ofwages or salaries, plus any bonuses and commissions.

Companies determine total wages for an employee by multiplying the hoursworked by the hourly rate of pay. In addition to the hourly pay rate, most compa-nies are required by law to pay hourly workers a minimum of 11⁄2 times the regularhourly rate for overtime work in excess of eight hours per day or 40 hours perweek. In addition, many employers pay overtime rates for work done at night, onweekends, and on holidays.

For example, assume that Michael Jordan, an employee of Academy Company,worked 44 hours for the weekly pay period ending January 14. His regular wage is$12 per hour. For any hours in excess of 40, the company pays at one-and-a-half timesthe regular rate.Academy computes Jordan’s gross earnings (total wages) as follows.

Compute and record the payrollfor a pay period.


Payroll DeductionsAs anyone who has received a paycheck knows, gross earnings are usually verydifferent from the amount actually received. The difference is due to payrolldeductions.

Payroll deductions may be mandatory or voluntary. Mandatory deductions arerequired by law and consist of FICA taxes and income taxes.Voluntary deductionsare at the option of the employee. Illustration D-4 summarizes common types ofpayroll deductions. Such deductions do not result in payroll tax expense to theemployer. The employer is merely a collection agent, and subsequently transfersthe deducted amounts to the government and designated recipients.

Determining the Payroll D5

Illustration D-4Payroll deductions

Gross Pay Net Pay

Federal Income Tax

FICA Taxes State and City Income Taxes

Insurance, Pensions, and/or Union Dues

Charity

1The Medicare provision also includes a tax of 1.45% on gross earnings in excess of $97,500. Inthe interest of simplification, we ignore this 1.45% charge in our end-of-chapter assignment mate-rial. We assume zero FICA withholdings on gross earnings above $97,500.

FICA TAXESIn 1937 Congress enacted the Federal Insurance Contribution Act (FICA). FICAtaxes are designed to provide workers with supplemental retirement, employment dis-ability, and medical benefits. In 1965, Congress extended benefits to include Medicarefor individuals over 65 years of age. The benefits are financed by a tax levied onemployees’ earnings. FICA taxes are commonly referred to as Social Security taxes.

Congress sets the tax rate and the tax base for FICA taxes. When FICA taxeswere first imposed, the rate was 1% on the first $3,000 of gross earnings, or a max-imum of $30 per year.The rate and base have changed dramatically since that time!In 2007, the rate was 7.65% (6.2% Social Security plus 1.45% Medicare) on thefirst $97,500 of gross earnings for each employee.1 For purpose of illustration inthis chapter, we will assume a rate of 8% on the first $97,500 of gross earnings, or amaximum of $7,800. Using the 8% rate, the FICA withholding for Jordan for theweekly pay period ending January 14 is $44.16 ($552 � 8%).

INCOME TAXESUnder the U.S. pay-as-you-go system of federal income taxes, employers arerequired to withhold income taxes from employees each pay period.Three variablesdetermine the amount to be withheld: (1) the employee’s gross earnings; (2) thenumber of allowances claimed by the employee; and (3) the length of the payperiod.

The number of allowances claimed typically includes the employee, his or herspouse, and other dependents. To indicate to the Internal Revenue Service thenumber of allowances claimed, the employee must complete an Employee’sWithholding Allowance Certificate (Form W-4). As shown in Illustration D-5,Michael Jordan claims two allowances on his W-4.


Illustration D-5W-4 form

W-4FormDepartment of the TreasuryInternal Revenue Service For Privacy Act and Paperwork Reduction Act Notice, see page 2.

Employee's Withholding Allowance Certificate OMB No. 1545-0010

1 Type or print your first name and middle initial Last nameMichael Jordan

2 Your social security number329-36-9547

Home address (number and street or rural route)2345 Mifflin Ave.

City or town, State, and ZIP codeHampton, MI 48292

3

4

Single MarriedxNote: If married, but legally separated, or spouse is a nonresident alien, check the Single box.

If your last name differs from that on your social security card, checkhere and call 1-800-772-1213 for a new card . . . . .

Married, but withhold at higher Single rate.

5 Total number of allowances you are claiming (from line H above or from the worksheet on page 2 if they apply)6 Additional amount, if any, you want withheld from each paycheck7 I claim exemption from withholding for 2006, and I certify that I meet BOTH of the following conditions for exemption:

• Last year I had a right to a refund of ALL Federal income tax withheld because I had NO tax liability AND• This year I expect a refund of ALL Federal income tax withheld because I expect to have NO tax liability.

8 Employer’s name and address (Employer: Complete 8 and 10 only if sending to the IRS) 9 Office code(optional)

10 Employer identification number

5 6

7If you meet both conditions, enter “Exempt” here

$2

Under penalties of perjury, I certify that I am entitled to the number of withholding allowances claimed on this certificate or entitled to claim exempt status.

Employee's signature Date

Cat. No. 102200

, 20 08September 1

Withholding tables furnished by the Internal Revenue Service indicate theamount of income tax to be withheld. Withholding amounts are based on grosswages and the number of allowances claimed. Separate tables are provided forweekly, biweekly, semimonthly, and monthly pay periods. Illustration D-6 (nextpage) shows the withholding tax table for Michael Jordan (assuming he earns$552 per week and claims two allowances). For a weekly salary of $552 with twoallowances, the income tax to be withheld is $49.

In addition, most states (and some cities) require employers to withholdincome taxes from employees’ earnings. As a rule, the amounts withheld are a per-centage (specified in the state revenue code) of the amount withheld for the fed-eral income tax. Or they may be a specified percentage of the employee’s earnings.For the sake of simplicity, we have assumed that Jordan’s wages are subject to stateincome taxes of 2%, or $11.04 (2% � $552) per week.

There is no limit on the amount of gross earnings subject to income tax with-holdings. In fact, under our progressive system of taxation, the higher the earnings,the higher the percentage of income withheld for taxes.

OTHER DEDUCTIONSEmployees may voluntarily authorize withholdings for charitable, retirement, andother purposes.All voluntary deductions from gross earnings should be authorizedin writing by the employee. The authorization(s) may be made individually or aspart of a group plan. Deductions for charitable organizations, such as the UnitedWay, or for financial arrangements, such as U.S. savings bonds and repayment of

loans from company credit unions, are made individually. Deductions for uniondues, health and life insurance, and pension plans are often made on a group basis.We will assume that Jordan has weekly voluntary deductions of $10 for the UnitedWay and $5 for union dues.

Net PayAcademy Company determines net pay by subtracting payroll deductions fromgross earnings. Illustration D-7 shows the computation of Jordan’s net pay for thepay period.

Determining the Payroll D7

Illustration D-6Withholding tax table

MARRIED Persons –– WEEKLY Payroll Period(For Wages Paid in 2008)

If the wages are —

At least But lessthan

And the number of withholding allowances claimed is —

The amount of income tax to be withheld is —

0 1 2 3 4 5 6 7 8 9 10

00000

00000

00000

02356

00000

00000

12457

810111314

00000

12457

810111314

1617192022

13467

910121315

1618192122

2425272830

910121315

1618192122

2425272830

3133343637

1718202123

2426272930

3233353638

3941424445

2426272930

3233353638

3941424445

4748505153

3234353738

4041434446

4749505253

5556585961

4042434546

4849515254

5557586061

6364666769

4849515254

5557586061

6364666769

7072737576

5657596062

6365666869

7172747577

7880818384

500510520530540

550560570580590

600610620630640

650660670680690

490500510520530

540550560570580

590600610620630

640650660670680

A L T E R N A T I V ET E R M I N O L O G Y

Net pay is also calledtake-home pay.

Gross earnings $552.00Payroll deductions:

FICA taxes $44.16Federal income taxes 49.00State income taxes 11.04United Way 10.00Union dues 5.00 119.20

Net pay $432.80

Illustration D-7Computation of net pay

Assuming that Michael Jordan’s wages for each week during the year are $552,total wages for the year are $28,704 (52 � $552).Thus, all of Jordan’s wages are sub-ject to FICA tax during the year. In comparison, let’s assume that Jordan’s depart-ment head earns $2,000 per week, or $104,000 for the year. Since only the first$97,500 is subject to FICA taxes, the maximum FICA withholdings on the depart-ment head’s earnings would be $7,800 ($97,500 � 8%).

Recording the payroll involves maintaining payroll department records, recogniz-ing payroll expenses and liabilities, and recording payment of the payroll.

Maintaining Payroll Department RecordsTo comply with state and federal laws, an employer must keep a cumulative recordof each employee’s gross earnings, deductions, and net pay during the year. Therecord that provides this information is the employee earnings record. IllustrationD-8 shows Michael Jordan’s employee earnings record.


Illustration D-8Employee earnings record

File Edit View Insert Format Tools Data Window Help

A DB C FE G H I J K L M N

ACADEMY COMPANYEmployee Earnings Record

For the Year 2008

87654321

9101112

1314151617181920

22

2324

21

Name

Social Security Number

Date of Birth

Date Employed

Sex

Single

Michael Jordan

329-36-9547

December 24, 1962

September 1, 2003

Male

x

Address

Telephone

Date Employment Ended

Exemptions

2345 Mifflin Ave.

Hampton, Michigan 48292

555-238-9051

2

Married

1,920.00 1,665.202,118.00 169.44 181.00 452.8042.36 40.00 20.00198.00

480.00

480.00480.00

480.0036.00

54.0036.00

72.0041.28

42.7241.28

44.1643.00

46.0043.00

49.0010.32

10.6810.32

11.0410.00

10.0010.00

10.005.00

5.005.00

5.00109.60

114.40109.60

119.20406.40

419.60406.40

432.80974

10771133

1028516.00

534.00516.00

552.00516.00

1,602.002,118.00

1,068.001/71/141/211/28Jan.Total

42444342

2008PeriodEnding

Gross Earnings Deductions PaymentTotalHours Regular Overtime Total Cumulative FICA

Fed.Inc. Tax

StateInc. Tax

UnitedWay

UnionDues Total

NetAmount

CheckNo.

RECORDING THE PAYROLL

Companies keep a separate earnings record for each employee, and update theserecords after each pay period.The employer uses the cumulative payroll data on theearnings record to: (1) determine when an employee has earned the maximum earn-ings subject to FICA taxes, (2) file state and federal payroll tax returns (as explainedlater), and (3) provide each employee with a statement of gross earnings and taxwithholdings for the year. (Illustration D-12 on page D13 shows this statement.)

In addition to employee earnings records, many companies find it useful toprepare a payroll register. This record accumulates the gross earnings, deductions,and net pay by employee for each pay period. It provides the documentation forpreparing a paycheck for each employee. Illustration D-9 (next page) presentsAcademy Company’s payroll register. It shows the data for Michael Jordan in thewages section. In this example, Academy Company’s total weekly payroll is$17,210, as shown in the gross earnings column.

Note that this record is a listing of each employee’s payroll data for the pay pe-riod. In some companies, a payroll register is a journal or book of original entry;

postings are made from the payroll register directly to ledger accounts. In othercompanies, the payroll register is a memorandum record that provides the data fora general journal entry and subsequent posting to the ledger accounts.At AcademyCompany, the latter procedure is followed.

Recognizing Payroll Expenses and LiabilitiesFrom the payroll register in Illustration D-9, Academy Company makes a journalentry to record the payroll. For the week ending January 14 the entry is:

Jan. 14 Office Salaries Expense 5,200.00Wages Expense 12,010.00

FICA Taxes Payable 1,376.80Federal Income Taxes Payable 3,490.00State Income Taxes Payable 344.20United Way Payable 421.50Union Dues Payable 115.00Salaries and Wages Payable 11,462.50

(To record payroll for the week endingJanuary 14)

The company credits specific liability accounts for the mandatory and voluntarydeductions made during the pay period. In the example, Academy debits OfficeSalaries Expense for the gross earnings of salaried office workers, and it debitsWages Expense for the gross earnings of employees who are paid at an hourly rate.Other companies may debit other accounts such as Store Salaries or Sales Salaries.The amount credited to Salaries and Wages Payable is the sum of the individualchecks the employees will receive.

Recording the Payroll D9

Illustration D-9Payroll register

File Edit View Insert Format Tools Data Window Help

A B C D E F G H I J K L M N O

ACADEMY COMPANYPayroll Register

For the Week Ending January 14, 2008

87654321

910

1213

11

141516171819202122232425

4040

40

4244 72.00

43

580.00590.00

530.005,200.00

480.00480.00

480.0011,000.0016,200.00

580.00590.00

530.005,200.00

516.00552.00

534.0012,010.0017,210.00

46.4047.20

42.40416.00

41.2844.16

42.72960.80

1,376.80

61.0063.00

54.001,090.00

43.0049.00

46.002,400.003,490.00

11.6011.80

10.60104.00

10.3211.04

10.68240.20344.20

15.0020.00

11.00120.00

18.0010.00

10.00301.50421.50

134.00142.00

118.001,730.00

117.60119.20

114.404,017.505,747.50

580.00590.00

530.005,200.00

5,200.00

446.00448.00

412.003,470.00

398.40432.80

419.607,992.50

11,462.50

516.00552.00

534.0012,010.0012,010.00

998999

1000

10251028

1029

5.005.00

5.00115.00115.00

54.001,010.001,010.00

36.00

Office SalariesArnold, Patricia

Mueller, WilliamSubtotal

WagesBennett, RobinJordan, Michael

SubtotalMilroy, Lee

Total

Canton, Matthew

Regular Gross FICA Total Net PayTotalHoursEmployee

Over-time

UnitedWay

UnionDues

CheckNo.

WagesExpense

FederalIncome

Tax

StateIncome

Tax

OfficeSalariesExpense

Earningsg Deductions Paid Accounts Debited

Cash Flowsno effect

A � L � SE�5,200.00 Exp

�12,010.00 Exp�1,376.80�3,490.00

�344.20�421.50�115.00

�11,462.50


REVIEW IT1. Identify two internal control procedures that apply to each payroll function.2. What are the primary sources of gross earnings?3. What payroll deductions are (a) mandatory and (b) voluntary?4. What account titles do companies use in recording a payroll, assuming only

mandatory payroll deductions are involved?

Before You Go On...

Illustration D-10Paycheck and statement ofearnings

H E L P F U L H I N TDo any of the incometax liabilities result inpayroll tax expense forthe employer?

Answer: No. Theemployer is acting onlyas a collection agent forthe government.

AC ACADEMY COMPANY19 Center St.

Hampton, MI 48291

Pay to theorder of

No. 1028

20

$

Dollars

City Bank & TrustP.O. Box 3000Hampton, MI 48291

For

62—1113

610

DETACH AND RETAIN THIS PORTION FOR YOUR RECORDS

NAME SOC. SEC. NO. EMPL. NUMBER NO. EXEMP PAY PERIOD ENDING

OTH. EARNINGS (2) GROSS

NET PAY

OTH. EARNINGS (1)REG. EARNINGSOTH. HRS. (2)OTH. HRS. (1)O.T. HRS.REG. HRS. O.T. EARNINGS

LOCAL TAXSTATE TAXFICAFED. W/H TAX OTHER DEDUCTIONS(1) (2) (3) (4)

Michael Jordan 329-36-9547 2 1/14/08

480.00 72.00440

44.1649.00 11.04 10.00 5.00

$552.00

432.80

NET PAYLOCAL TAXSTATE TAXFICAFED. W/H TAX OTHER DEDUCTIONS(1) (2) (3) (4)

85.4492.00 21.36 20.00 10.00 $839.20

YEAR TO DATE

A � L � OE�11,462.50

�11,462.50

Cash Flows�11,462.50

Recording Payment of the PayrollA company makes payments by check (or electronic funds transfer) either from itsregular bank account or a payroll bank account. Each paycheck is usually accompa-nied by a detachable statement of earnings document.This shows the employee’s grossearnings, payroll deductions, and net pay, both for the period and for the year-to-date.Academy Company uses its regular bank account for payroll checks. Illustration D-10shows the paycheck and statement of earnings for Michael Jordan.

Following payment of the payroll, the company enters the check numbers inthe payroll register. Academy Company records payment of the payroll as follows.

Jan. 14 Salaries and Wages Payable 11,462.50Cash 11,462.50

(To record payment of payroll)

When a company uses currency in payment, it prepares one check for the pay-roll’s total amount of net pay. The company cashes this check, and inserts the coinsand currency in individual pay envelopes for disbursement to individual employees.

Payroll tax expense for businesses results from three taxes that govern-mental agencies levy on employers. These taxes are: (1) FICA, (2) federalunemployment tax, and (3) state unemployment tax.These taxes plus suchitems as paid vacations and pensions (discussed in the appendix to thischapter) are collectively referred to as fringe benefits.As indicated earlier, the costof fringe benefits in many companies is substantial. The pie chart in the marginshows the pieces of the benefits “pie.”

FICA TaxesEach employee must pay FICA taxes. In addition, employers must match eachemployee’s FICA contribution. The matching contribution results in payroll taxexpense to the employer. The employer’s tax is subject to the same rate and maxi-mum earnings as the employee’s.The company uses the same account, FICA TaxesPayable, to record both the employee’s and the employer’s FICA contributions.For the January 14 payroll, Academy Company’s FICA tax contribution is$1,376.80 ($17,210.00 � 8%).

Federal Unemployment TaxesThe Federal Unemployment Tax Act (FUTA) is another feature of the federalSocial Security program. Federal unemployment taxes provide benefits for a lim-ited period of time to employees who lose their jobs through no fault of theirown. The FUTA tax rate is 6.2% of taxable wages. The taxable wage base is thefirst $7,000 of wages paid to each employee in a calendar year. Employers who

Employer Payroll Taxes D11

DO ITYour cousin Stan is establishing a house-cleaning business and will have a num-ber of employees working for him. He is aware that documentation proceduresare an important part of internal control. But he is unsure about the differencebetween an employee earnings record and a payroll register. He asks you toexplain the principal differences, because he wants to be sure that he sets up theproper payroll procedures.

Action Plan■ Determine the earnings and deductions data that must be recorded and re-

ported for each employee.■ Design a record that will accumulate earnings and deductions data and will

serve as a basis for journal entries to be prepared and posted to the generalledger accounts.

■ Explain the difference between the employee earnings record and the payrollregister.

Solution An employee earnings record is kept for each employee. It showsgross earnings, payroll deductions, and net pay for each pay period, as wellas cumulative payroll data for that employee. In contrast, a payroll registeris a listing of all employees’ gross earnings, payroll deductions, and net payfor each pay period. It is the documentation for preparing paychecks and forrecording the payroll. Of course, Stan will need to keep both documents.

Related exercise material: BED-1, BED-3, and ED-1.

Describe and record employerpayroll taxes.


EMPLOYER PAYROLL TAXES

BENEFITS3% Disability and life insurance

23% Legally required benefitssuch as Social Security

24% Medical benefits

37% Vacation and other benefitssuch as parental and sick leaves, child care

13% Retirement incomesuch as pensions

H E L P F U L H I N TBoth the employer andemployee pay FICAtaxes. Federal unem-ployment taxes and (in most states) thestate unemploymenttaxes are borne entirelyby the employer.

pay the state unemployment tax on a timely basis will receive an offset credit ofup to 5.4%. Therefore, the net federal tax rate is generally 0.8% (6.2%–5.4%).This rate would equate to a maximum of $56 of federal tax per employee per year(.008 � $7,000). State tax rates are based on state law.

The employer bears the entire federal unemployment tax.There is no deductionor withholding from employees. Companies use the account Federal UnemploymentTaxes Payable to recognize this liability. The federal unemployment tax forAcademy Company for the January 14 payroll is $137.68 ($17,210.00 � 0.8%).

State Unemployment TaxesAll states have unemployment compensation programs under state unemploymenttax acts (SUTA). Like federal unemployment taxes, state unemployment taxes pro-vide benefits to employees who lose their jobs. These taxes are levied on employers.2

The basic rate is usually 5.4% on the first $7,000 of wages paid to an employee duringthe year.The state adjusts the basic rate according to the employer’s experience rating:Companies with a history of stable employment may pay less than 5.4%. Companieswith a history of unstable employment may pay more than the basic rate. Regardlessof the rate paid, the company’s credit on the federal unemployment tax is still 5.4%.

Companies use the account State Unemployment Taxes Payable for this liabil-ity. The state unemployment tax for Academy Company for the January 14 payrollis $929.34 ($17,210.00 � 5.4%). Illustration D-11 summarizes the types of em-ployer payroll taxes.


2In a few states, the employee is also required to make a contribution. In this textbook, includingthe homework, we will assume that the tax is only on the employer.

Illustration D-11Employer payroll taxes

Federal Unemployment Taxes

FICA Taxes

State Unemployment Taxes

ComputationBased

on Wages

Recording Employer Payroll TaxesCompanies usually record employer payroll taxes at the same time they record thepayroll. The entire amount of gross pay ($17,210.00) shown in the payroll registerin Illustration D-9 is subject to each of the three taxes mentioned above.Accordingly,Academy records the payroll tax expense associated with the January14 payroll with the entry shown on page D13.

Jan. 14 Payroll Tax Expense 2,443.82FICA Taxes Payable 1,376.80Federal Unemployment Taxes Payable 137.68State Unemployment Taxes Payable 929.34

(To record employer’s payroll taxes on January 14 payroll)

Note that Academy uses separate liability accounts instead of a single credit toPayroll Taxes Payable. Why? Because these liabilities are payable to different tax-ing authorities at different dates. Companies classify the liability accounts in thebalance sheet as current liabilities since they will be paid within the next year.Theyclassify Payroll Tax Expense on the income statement as an operating expense.

Filing and Remitting Payroll Taxes D13

A � L � SE�2,443.82 Exp

�1,376.80�137.68�929.34

Cash Flowsno effect

FILING AND REMITTING PAYROLL TAXESPreparation of payroll tax returns is the responsibility of the payroll department.The treasurer’s department makes the tax payment. Much of the information forthe returns is obtained from employee earnings records.

For purposes of reporting and remitting to the IRS, the Company combines theFICA taxes and federal income taxes that it withheld. Companies must report thetaxes quarterly, no later than one month following the close of each quarter. Theremitting requirements depend on the amount of taxes withheld and the length ofthe pay period. Companies remit funds through deposits in either a FederalReserve bank or an authorized commercial bank.

Companies generally file and remit federal unemployment taxes annually onor before January 31 of the subsequent year. Earlier payments are required whenthe tax exceeds a specified amount. Companies usually must file and pay stateunemployment taxes by the end of the month following each quarter.When payrolltaxes are paid, companies debit payroll liability accounts, and credit Cash.

Employers also must provide each employee with a Wage and Tax Statement(Form W-2) by January 31 following the end of a calendar year. This statementshows gross earnings, FICA taxes withheld, and income taxes withheld for theyear. The required W-2 form for Michael Jordan, using assumed annual data, isshown in Illustration D-12. The employer must send a copy of each employee’s

Illustration D-12W-2 form

Form W-2 Wage and Tax Statement Calendar Year 20081 Control number

2 Employer's name, address and ZIP code

8 Employee's social security number 9 Federal income tax withheld

12 Employee's name, address, and ZIP code

3 Employer's identification number 4 Employer's State number

6 Allocated tips 7 Advance EIC payment

10 Wages, tips, other compensation 11 Social security tax withheld

13 Social security wages 14 Social security tips

16

17 State income tax

20 Local income tax

18 State wages, tips, etc.

21 Local wages, tips, etc.

19 Name of State

22 Name of locality

5 Stat.employee

Deceased Legalrep.

942emp.

Subtotal Void

OMB No. 1545-0008

329-36-9547 $2,248.00

Michael Jordan2345 Mifflin Ave.Hampton, MI 48292

Academy Company19 Center St.Hampton, MI 48291

36-2167852

$26,300.00

$26,300.00

$2,104.00

$526.00 Michigan

H E L P F U L H I N TEmployers generallytransmit their W-2s tothe government elec-tronically. The taxingagencies store the infor-mation in their com-puter systems forsubsequent comparisonagainst earnings andtaxes withheld reportedon employees’ incometax returns.

Wage and Tax Statement (Form W-2) to the Social Security Administration. Thisagency subsequently furnishes the Internal Revenue Service with the income datarequired.


REVIEW IT1. What payroll taxes do governments levy on employers?2. What accounts are involved in accruing employer payroll taxes?

DO ITIn January, the payroll supervisor determines that gross earnings for HaloCompany are $70,000. All earnings are subject to 8% FICA taxes, 5.4% stateunemployment taxes, and 0.8% federal unemployment taxes. Halo asks you torecord the employer’s payroll taxes.

Action Plan■ Compute the employer’s payroll taxes on the period’s gross earnings.■ Identify the expense account(s) to be debited.■ Identify the liability account(s) to be credited.

Solution The entry to record the employer’s payroll taxes is:

Payroll Tax Expense 9,940FICA Taxes Payable ($70,000 � 8%) 5,600Federal Unemployment Taxes Payable ($70,000 � 0.8%) 560State Unemployment Taxes Payable ($70,000 � 5.4%) 3,780

(To record employer’s payroll taxes on January payroll)

Related exercise material: BED-2, BED-3, BED-4, ED-1, ED-2, ED-3, ED-4, and ED-5.

Before You Go On...

Demonstration Problem

Indiana Jones Company had the following selected transactions.Feb. 1 Signs a $50,000, 6-month, 9%-interest-bearing note payable to

CitiBank and receives $50,000 in cash.10 Cash register sales total $43,200, which includes an 8% sales tax.28 The payroll for the month consists of Sales Salaries $32,000 and Office

Salaries $18,000. All wages are subject to 8% FICA taxes. A total of$8,900 federal income taxes are withheld. The salaries are paid onMarch 1.

28 The following adjustment data are developed.1. Interest expense of $375 has been incurred on the note.2. Employer payroll taxes include 8% FICA taxes, a 5.4% state

unemployment tax, and a 0.8% federal unemployment tax.

Instructions(a) Journalize the February transactions.(b) Journalize the adjusting entries at February 28.

Glossary D15

Solution(a) Feb. 1 Cash 50,000

Notes Payable 50,000(Issued 6-month, 9%-interest-bearing note toCitiBank)

10 Cash 43,200Sales ($43,200 � 1.08) 40,000Sales Taxes Payable ($40,000 � 8%) 3,200

(To record sales and sales taxes payable)28 Sales Salaries Expense 32,000

Office Salaries Expense 18,000FICA Taxes Payable (8% � $50,000) 4,000Federal Income Taxes Payable 8,900Salaries Payable 37,100

(To record February salaries)(b) Feb. 28 Interest Expense 375

Interest Payable 375(To record accrued interest for February)

28 Payroll Tax Expense 7,100FICA Taxes Payable 4,000Federal Unemployment Taxes Payable 400(0.8% � $50,000)State Unemployment Taxes Payable 2,700(5.4% � $50,000)

(To record employer’s payroll taxes onFebruary payroll)

1 Discuss the objectives of internal control for payroll.The objectives of internal control for payroll are (1) tosafeguard company assets against unauthorized paymentsof payrolls, and (2) to ensure the accuracy and reliability ofthe accounting records pertaining to payrolls.

2 Compute and record the payroll for a pay period. Thecomputation of the payroll involves gross earnings, payrolldeductions, and net pay. In recording the payroll, Salaries(or Wages) Expense is debited for gross earnings, individ-ual tax and other liability accounts are credited for payroll

deductions, and Salaries (Wages) Payable is credited fornet pay. When the payroll is paid, Salaries and WagesPayable is debited, and Cash is credited.

3 Describe and record employer payroll taxes. Employerpayroll taxes consist of FICA, federal unemployment taxes,and state unemployment taxes. The taxes are usuallyaccrued at the time the payroll is recorded by debitingPayroll Tax Expense and crediting separate liabilityaccounts for each type of tax.

SUMMARY OF STUDY OBJECTIVES

GLOSSARYBonus Compensation to management personnel and other

employees, based on factors such as increased sales or theamount of net income. (p. D4).

Employee earnings record A cumulative record of eachemployee’s gross earnings, deductions, and net pay duringthe year. (p. D8).

Employee’s Withholding Allowance Certificate (Form W-4)An Internal Revenue Service form on which the employeeindicates the number of allowances claimed for withhold-ing federal income taxes. (p. D6).

Federal unemployment taxes Taxes imposed on theemployer that provide benefits for a limited time period toemployees who lose their jobs through no fault of theirown. (p. D11).

Fees Payments made for the services of professionals. (p. D1).FICA taxes Taxes designed to provide workers with supple-

mental retirement, employment disability, and medicalbenefits. (p. D5).

Gross earnings Total compensation earned by an em-ployee. (p. D4).

action plan✔ To determine sales, dividethe cash register total by100% plus the sales taxpercentage.✔ Base payroll taxes ongross earnings.

Net pay Gross earnings less payroll deductions. (p. D7).

Payroll deductions Deductions from gross earnings todetermine the amount of a paycheck. (p. D5).

Payroll register A payroll record that accumulates thegross earnings, deductions, and net pay by employee foreach pay period. (p. D8).

Salaries Specified amount per month or per year paid tomanagerial, administrative, and sales personnel. (p. D1).

Statement of earnings A document attached to a paycheckthat indicates the employee’s gross earnings, payroll de-ductions, and net pay. (p. D10).

State unemployment taxes Taxes imposed on the em-ployer that provide benefits to employees who lose theirjobs. (p. D12).

Wage and Tax Statement (Form W-2) A form showinggross earnings, FICA taxes withheld, and income taxeswithheld which is prepared annually by an employer foreach employee. (p. D13).

Wages Amounts paid to employees based on a rate perhour or on a piece-work basis. (p. D1).


SELF-STUDY QUESTIONSAnswers are at the end of the appendix.

1. The department that should pay the payroll is the:a. timekeeping department.b. human resources department.c. payroll department.d. treasurer’s department.

2. J. Barr earns $14 per hour for a 40-hour week and $21 perhour for any overtime work. If Barr works 45 hours in aweek, gross earnings are:a. $560.b. $630.

c. $650.d. $665.

3. Employer payroll taxes do not include:a. federal unemployment taxes.b. state unemployment taxes.c. federal income taxes.d. FICA taxes.

Go to the book’s website,www.wiley.com/college/weygandt,for Additional Self-Study questions.

QUESTIONS1. You are a newly hired accountant with Schindlebeck

Company. On your first day, the controller asks you toidentify the main internal control objectives related topayroll accounting. How would you respond?

2. What are the four functions associated with payroll activ-ities?

3. What is the difference between gross pay and net pay?Which amount should a company record as wages orsalaries expense?

4. Which payroll tax is levied on both employers and em-ployees?

5. Are the federal and state income taxes withheld fromemployee paychecks a payroll tax expense for the em-ployer? Explain your answer.

6. What do the following acronyms stand for: FICA, FUTA,and SUTA?

7. What information is shown on a W-4 statement? On a W-2statement?

8. Distinguish between the two types of payroll deduc-tions and give examples of each.

9. What are the primary uses of the employee earningsrecord?

10. (a) Identify the three types of employer payroll taxes.(b) How are tax liability accounts and Payroll TaxExpense classified in the financial statements?

BRIEF EXERCISESBED-1 Hernandez Company has the following payroll procedures.

(a) Supervisor approves overtime work.(b) The human resources department prepares hiring authorization forms for new hires.(c) A second payroll department employee verifies payroll calculations.(d) The treasurer’s department pays employees.

Identify the payroll function to which each procedure pertains.

Identify payroll functions.

(SO 1)

(SO 1)

(SO 2)

(SO 3)

BED-2 Sandy Teter’s regular hourly wage rate is $16, and she receives an hourly rate of $24 forwork in excess of 40 hours. During a January pay period, Sandy works 45 hours. Sandy’s federalincome tax withholding is $95, and she has no voluntary deductions. Compute Sandy Teter’s grossearnings and net pay for the pay period.

BED-3 Data for Sandy Teter are presented in BED-2. Prepare the journal entries to record (a)Sandy’s pay for the period and (b) the payment of Sandy’s wages. Use January 15 for the end ofthe pay period and the payment date.

BED-4 In January, gross earnings in Yoon Company totaled $90,000.All earnings are subject to8% FICA taxes, 5.4% state unemployment taxes, and 0.8% federal unemployment taxes. Preparethe entry to record January payroll tax expense.

Exercises D17

Compute gross earnings andnet pay.

(SO 2)

Record a payroll and thepayment of wages.

(SO 2)

Record employer payroll taxes.

(SO 3)

EXERCISESED-1 Betty Williams’ regular hourly wage rate is $14, and she receives a wage of 11⁄2 times theregular hourly rate for work in excess of 40 hours. During a March weekly pay period Bettyworked 42 hours. Her gross earnings prior to the current week were $6,000. Betty is married andclaims three withholding allowances. Her only voluntary deduction is for group hospitalizationinsurance at $15 per week.

Instructions(a) Compute the following amounts for Betty’s wages for the current week.

(1) Gross earnings.(2) FICA taxes. (Assume an 8% rate on maximum of $97,500.)(3) Federal income taxes withheld. (Use the withholding table in the text, page D7.)(4) State income taxes withheld. (Assume a 2.0% rate.)(5) Net pay.

(b) Record Betty’s pay, assuming she is an office computer operator.

ED-2 Employee earnings records for Brantley Company reveal the following gross earningsfor four employees through the pay period of December 15.

C. Mays $83,500 D. Delgado $95,700L. Jeter $95,200 T. Rolen $97,500

For the pay period ending December 31, each employee’s gross earnings is $3,000. Employeesare required to pay a FICA tax rate of 8% gross earnings of $97,500.

InstructionsCompute the FICA withholdings that should be made for each employee for the December 31pay period. (Show computations.)

ED-3 Piniella Company has the following data for the weekly payroll ending January 31.

Hours Federal Hourly Income Tax Health

Employee M T W T F S Rate Withholding Insurance

M. Hindi 8 8 9 8 10 3 $11 $34 $10E. Benson 8 8 8 8 8 2 13 37 15K. Estes 9 10 8 8 9 0 14 58 15

Employees are paid 11⁄2 times the regular hourly rate for all hours worked in excess of 40 hoursper week. FICA taxes are 8% on the first $97,500 of gross earnings. Piniella Company is subjectto 5.4% state unemployment taxes on the first $9,800 and 0.8% federal unemployment taxes onthe first $7,000 of gross earnings.

Instructions(a) Prepare the payroll register for the weekly payroll.(b) Prepare the journal entries to record the payroll and Piniella’s payroll tax expense.

Compute net pay and recordpay for one employee.

(SO 2)

Compute maximum FICA deductions.

(SO 2)

Prepare payroll register andrecord payroll and payroll taxexpense.

(SO 2, 3)

ED-4 Selected data from a February payroll register for Landmark Company are presentedbelow. Some amounts are intentionally omitted.

Gross earnings:Regular $8,900 State income taxes $(3)Overtime (1) Union dues 100

Total (2) Total deductions (4)Deductions: Net pay $7,215

FICA taxes $ 760 Accounts debited:Federal income taxes 1,140 Warehouse wages (5)

Store wages $4,000

FICA taxes are 8%. State income taxes are 3% of gross earnings.

Instructions(a) Fill in the missing amounts.(b) Journalize the February payroll and the payment of the payroll.

ED-5 According to a payroll register summary of Cruz Company, the amount of employees’gross pay in December was $850,000, of which $70,000 was not subject to FICA tax and $760,000was not subject to state and federal unemployment taxes.

Instructions(a) Determine the employer’s payroll tax expense for the month, using the following rates:

FICA 8%, state unemployment 5.4%, federal unemployment 0.8%.(b) Prepare the journal entry to record December payroll tax expense.


Compute missing payrollamounts and record payroll.

(SO 2)

Determine employer’s payrolltaxes; record payroll tax expense.

(SO 3)

EXERCISES: SET BVisit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B.

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e/weygandt

PROBLEMS: SET APD-1A The payroll procedures used by three different companies are described below.

1. In Brewer Company each employee is required to mark on a clock card the hoursworked. At the end of each pay period, the employee must have this clock cardapproved by the department manager. The approved card is then given to the payrolldepartment by the employee. Subsequently, the treasurer’s department pays theemployee by check.

2. In Hilyard Computer Company clock cards and time clocks are used. At the end of eachpay period, the department manager initials the cards, indicates the rates of pay, and sendsthem to payroll. A payroll register is prepared from the cards by the payroll department.Cash equal to the total net pay in each department is given to the department manager,who pays the employees in cash.

3. In Hyun-chan Company employees are required to record hours worked by “punching”clock cards in a time clock. At the end of each pay period, the clock cards are collected bythe department manager. The manager prepares a payroll register in duplicate andforwards the original to payroll. In payroll, the summaries are checked for mathematicalaccuracy, and a payroll supervisor pays each employee by check.

Instructions(a) Indicate the weakness(es) in internal control in each company.(b) For each weakness, describe the control procedure(s) that will provide effective internal

control. Use the following format for your answer:

(a) Weaknesses (b) Recommended Procedures

Identify internal control weaknesses and make recommendations for improvement.

(SO 1)

PD-2A Graves Drug Store has four employees who are paid on an hourly basis plus time-and-a-half for all hours worked in excess of 40 a week. Payroll data for the week ended February 15,2008, are presented below.

Federal Hours Hourly Income Tax United

Employees Worked Rate Withholdings Way

L. Leiss 39 $14.00 $ ? $–0–S. Bjork 42 $12.00 ? 5.00M. Cape 44 $12.00 61 7.50L. Wild 48 $12.00 52 5.00

Leiss and Bjork are married. They claim 2 and 4 withholding allowances, respectively. The fol-lowing tax rates are applicable: FICA 8%, state income taxes 3%, state unemployment taxes5.4%, and federal unemployment 0.8%. The first three employees are sales clerks (store wagesexpense). The fourth employee performs administrative duties (office wages expense).

Instructions(a) Prepare a payroll register for the weekly payroll. (Use the wage-bracket withholding table

in the text for federal income tax withholdings.)(b) Journalize the payroll on February 15, 2008, and the accrual of employer payroll taxes.(c) Journalize the payment of the payroll on February 16, 2008.(d) Journalize the deposit in a Federal Reserve bank on February 28, 2008, of the FICA and

federal income taxes payable to the government.

PD-3A The following payroll liability accounts are included in the ledger of Eikleberry Com-pany on January 1, 2008.

FICA Taxes Payable $ 662.20Federal Income Taxes Payable 1,254.60State Income Taxes Payable 102.15Federal Unemployment Taxes Payable 312.00State Unemployment Taxes Payable 1,954.40Union Dues Payable 250.00U.S. Savings Bonds Payable 350.00

In January, the following transactions occurred.

Jan. 10 Sent check for $250.00 to union treasurer for union dues.12 Deposited check for $1,916.80 in Federal Reserve bank for FICA taxes and federal

income taxes withheld.15 Purchased U.S. Savings Bonds for employees by writing check for $350.00.17 Paid state income taxes withheld from employees.20 Paid federal and state unemployment taxes.31 Completed monthly payroll register, which shows office salaries $17,600, store wages

$27,400, FICA taxes withheld $3,600, federal income taxes payable $1,770, state incometaxes payable $360, union dues payable $400, United Fund contributions payable$1,800, and net pay $37,070.

31 Prepared payroll checks for the net pay and distributed checks to employees.

At January 31, the company also makes the following accrual for employer payroll taxes: FICAtaxes 8%, state unemployment taxes 5.4%, and federal unemployment taxes 0.8%.

Instructions(a) Journalize the January transactions.(b) Journalize the adjustments pertaining to employee compensation at January 31.

Problems: Set A D19

Prepare payroll register andpayroll entries.

(SO 2, 3)

(a) Net pay $1,786.32; Storewages expense $1,614.00

(b) Payroll tax expense$317.79

Journalize payroll transactionsand adjusting entries.

(SO 2, 3)

(b) Payroll tax expense$6,390.00

PD-4A For the year ended December 31, 2008, R. Visnak Company reports the followingsummary payroll data.

Gross earnings:Administrative salaries $180,000Electricians’ wages 320,000

Total $500,000

Deductions:FICA taxes $ 35,200Federal income taxes withheld 153,000State income taxes withheld (2.6%) 13,000United Way contributions payable 25,000

*Hospital insurance premiums 15,800

Total $242,000

R. Visnak Company’s payroll taxes are: FICA 8%, state unemployment 2.5% (due to a stableemployment record), and 0.8% federal unemployment. Gross earnings subject to FICA taxestotal $440,000, and unemployment taxes total $110,000.

Instructions(a) Prepare a summary journal entry at December 31 for the full year’s payroll.(b) Journalize the adjusting entry at December 31 to record the employer’s payroll taxes.(c) The W-2 Wage and Tax Statement requires the following dollar data.

Wages, Tips, Federal Income State Income FICA FICA TaxOther Compensation Tax Withheld Tax Withheld Wages Withheld

Complete the required data for the following employees.

Employee Gross Earnings Federal Income Tax WithheldR. Lopez $60,000 $27,500K. Kirk 27,000 11,000


Prepare entries for payroll andpayroll taxes; prepare W-2 data.

(SO 2, 3)

PROBLEMS: SET BPD-1B Selected payroll procedures of Wallace Company are described below.

1. Department managers interview applicants and on the basis of the interview either hire orreject the applicants. When an applicant is hired, the applicant fills out a W-4 form(Employee’s Withholding Allowance Certificate). One copy of the form is sent to the human resources department, and one copy is sent to the payroll department as notice thatthe individual has been hired. On the copy of the W-4 sent to payroll, the managers manuallyindicate the hourly pay rate for the new hire.

2. The payroll checks are manually signed by the chief accountant and given to the departmentmanagers for distribution to employees in their department.The managers are responsible forseeing that any absent employees receive their checks.

3. There are two clerks in the payroll department. The payroll is divided alphabetically; oneclerk has employees A to L and the other has employees M to Z. Each clerk computes thegross earnings, deductions, and net pay for employees in the section and posts the data tothe employee earnings records.

Instructions(a) Indicate the weaknesses in internal control.(b) For each weakness, describe the control procedures that will provide effective internal con-

trol. Use the following format for your answer:

(a) Weaknesses (b) Recommended Procedures

Identify internal control weaknesses and make recommendations for improvement.

(SO 1)

(a) Wages Payable $258,000(b) Payroll tax expense

$38,830

PD-2B Lee Hardware has four employees who are paid on an hourly basis plus time-and-ahalf for all hours worked in excess of 40 a week. Payroll data for the week ended March 15, 2008,are presented below.

Federal Hours Hourly Income Tax United

Employee Worked Rate Withholdings Way

Joe Coomer 40 $15.00 $? $5.00Mary Walker 42 13.00 ? 5.00Andy Dye 44 13.00 60 8.00Kim Shen 48 13.00 67 5.00

Coomer and Walker are married. They claim 0 and 4 withholding allowances, respectively. Thefollowing tax rates are applicable: FICA 8%, state income taxes 3%, state unemployment taxes5.4%, and federal unemployment 0.8%. The first three employees are sales clerks (store wagesexpense). The fourth employee performs administrative duties (office wages expense).

Instructions(a) Prepare a payroll register for the weekly payroll. (Use the wage-bracket withholding table in

the text for federal income tax withholdings.)(b) Journalize the payroll on March 15, 2008, and the accrual of employer payroll taxes.(c) Journalize the payment of the payroll on March 16, 2008.(d) Journalize the deposit in a Federal Reserve bank on March 31, 2008, of the FICA and federal

income taxes payable to the government.

PD-3B The following payroll liability accounts are included in the ledger of NordlundCompany on January 1, 2008.

FICA Taxes Payable $ 760.00Federal Income Taxes Payable 1,204.60State Income Taxes Payable 108.95Federal Unemployment Taxes Payable 288.95State Unemployment Taxes Payable 1,954.40Union Dues Payable 870.00U.S. Savings Bonds Payable 360.00

In January, the following transactions occurred.

Jan. 10 Sent check for $870.00 to union treasurer for union dues.12 Deposited check for $1,964.60 in Federal Reserve bank for FICA taxes and federal in-

come taxes withheld.15 Purchased U.S. Savings Bonds for employees by writing check for $360.00.17 Paid state income taxes withheld from employees.20 Paid federal and state unemployment taxes.31 Completed monthly payroll register, which shows office salaries $21,600, store wages

$28,400, FICA taxes withheld $4,000, federal income taxes payable $1,958, state incometaxes payable $414, union dues payable $400, United Fund contributions payable$1,888, and net pay $41,340.

31 Prepared payroll checks for the net pay and distributed checks to employees.

At January 31, the company also makes the following accrued adjustment for employer pay-roll taxes: FICA taxes 8%, federal unemployment taxes 0.8%, and state unemployment taxes5.4%.

Instructions(a) Journalize the January transactions.(b) Journalize the adjustments pertaining to employee compensation at January 31.

Problems: Set B D21

(a) Net pay $1,910.37; Storewages expense $1,757

(b) Payroll tax expense$345.48

Prepare payroll register andpayroll entries.

(SO 2, 3)

Journalize payroll transactionsand adjusting entries.

(SO 2, 3)

(b) Payroll tax expense$7,100

PD-4B For the year ended December 31, 2008, Niehaus Electrical Repair Company reportsthe following summary payroll data.

Gross earnings:Administrative salaries $180,000Electricians’ wages 370,000

Total $550,000

Deductions:FICA taxes $ 38,000Federal income taxes withheld 168,000State income taxes withheld (2.6%) 14,300United Way contributions payable 27,500*Hospital insurance premiums 17,200

Total $265,000

Niehaus Company’s payroll taxes are: FICA 8%, state unemployment 2.5% (due to a stable em-ployment record), and 0.8% federal unemployment. Gross earnings subject to FICA taxes total$475,000, and unemployment taxes total $125,000.

Instructions(a) Prepare a summary journal entry at December 31 for the full year’s payroll.(b) Journalize the adjusting entry at December 31 to record the employer’s payroll taxes.(c) The W-2 Wage and Tax Statement requires the following dollar data.

Wages, Tips, Federal Income State Income FICA FICAOther Compensation Tax Withheld Tax Withheld Wages Tax Withheld

Complete the required data for the following employees.

Employee Gross Earnings Federal Income Tax Withheld

Anna Hashmi $59,000 $28,500Sharon Bishop 26,000 10,200


Prepare entries for payroll andpayroll taxes; prepare W-2 data.

(SO 2, 3)

(a) Wages payable $285,000(b) Payroll tax expense

$42,125

PROBLEMS: SET CVisit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set C.

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Exploring the WebBYPD-1 The Internal Revenue Service provides considerable information over the Internet.The following demonstrates how useful one of its sites is in answering payroll tax questionsfaced by employers.

Address: www.irs.ustreas.gov/formspubs/index.html, or go to www.wiley.com/college/weygandt

Steps1. Go to the site shown above.2. Choose View Online, Tax Publications.3. Choose Publication 15, Circular E, Employer’s Tax Guide.

BROADENING YOUR PERSPECTIVEFINANCIAL REPORTING AND ANALYSIS

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InstructionsAnswer each of the following questions.

(a) How does the government define “employees”?(b) What are the special rules for Social Security and Medicare regarding children who are em-

ployed by their parents?(c) How can an employee obtain a Social Security card if he or she doesn’t have one?(d) Must employees report to their employer tips received from customers? If so, what is the

process?(e) Where should the employer deposit Social Security taxes withheld or contributed?

Broadening Your Perspective D23

CRITICAL THINKINGDecision Making Across the OrganizationBYPD-2 Summerville Processing Company provides word-processing services for businessclients and students in a university community. The work for business clients is fairly steadythroughout the year. The work for students peaks significantly in December and May as a re-sult of term papers, research project reports, and dissertations.

Two years ago, the company attempted to meet the peak demand by hiring part-time help.However, this led to numerous errors and considerable customer dissatisfaction. A year ago, thecompany hired four experienced employees on a permanent basis instead of using part-timehelp.This proved to be much better in terms of productivity and customer satisfaction. But, it hascaused an increase in annual payroll costs and a significant decline in annual net income.

Recently, Valarie Flynn, a sales representative of Davidson Services Inc., has made a pro-posal to the company. Under her plan, Davidson Services will provide up to four experiencedworkers at a daily rate of $80 per person for an 8-hour workday. Davidson workers are not avail-able on an hourly basis. Summerville Processing would have to pay only the daily rate for theworkers used.

The owner of Summerville Processing, Nancy Bell, asks you, as the company’s accountant,to prepare a report on the expenses that are pertinent to the decision. If the Davidson plan isadopted, Nancy will terminate the employment of two permanent employees and will keep twopermanent employees. At the moment, each employee earns an annual income of $22,000.Summerville Processing pays 8% FICA taxes, 0.8% federal unemployment taxes, and 5.4% stateunemployment taxes.The unemployment taxes apply to only the first $7,000 of gross earnings. Inaddition, Summerville Processing pays $40 per month for each employee for medical and dentalinsurance.

Nancy indicates that if the Davidson Services plan is accepted, her needs for workers will beas follows.

WorkingMonths Number Days per Month

January–March 2 20April–May 3 25June–October 2 18November–December 3 23

InstructionsWith the class divided into groups, answer the following.

(a) Prepare a report showing the comparative payroll expense of continuing to employ per-manent workers compared to adopting the Davidson Services Inc. plan.

(b) What other factors should Nancy consider before finalizing her decision?

Communication ActivityBYPD-3 Ivan Blanco, president of the Blue Sky Company, has recently hired a number ofadditional employees. He recognizes that additional payroll taxes will be due as a result of thishiring, and that the company will serve as the collection agent for other taxes.

InstructionsIn a memorandum to Ivan Blanco, explain each of the taxes, and identify the taxes that result inpayroll tax expense to Blue Sky Company.

Ethics CaseBYPD-4 Johnny Fuller owns and manages Johnny’s Restaurant, a 24-hour restaurant near thecity’s medical complex. Johnny employs 9 full-time employees and 16 part-time employees. Hepays all of the full-time employees by check, the amounts of which are determined by Johnny’spublic accountant, Mary Lake. Johnny pays all of his part-time employees in cash. He computestheir wages and withdraws the cash directly from his cash register.

Mary has repeatedly urged Johnny to pay all employees by check. But as Johnny has told hiscompetitor and friend, Steve Hill, who owns the Greasy Diner, “First of all, my part-time em-ployees prefer the cash over a check, and secondly I don’t withhold or pay any taxes or work-men’s compensation insurance on those wages because they go totally unrecorded and unnoticed.”

Instructions(a) Who are the stakeholders in this situation?(b) What are the legal and ethical considerations regarding Johnny’s handling of his payroll?(c) Mary Lake is aware of Johnny’s payment of the part-time payroll in cash. What are her

ethical responsibilities in this case?(d) What internal control principle is violated in this payroll process?

Answers to Self-Study Questions1. d 2. d 3. c


E1

Subsidiary Ledgers and Special Journals

Appendix E

SECTION 1 Expanding the Ledger—Subsidiary Ledgers

After studying this appendix, you should be able to:1. Describe the nature and purpose of a subsidiary ledger.2. Explain how companies use special journals in journalizing.3. Indicate how companies post a multi-column journal.

S T U D Y O B J E C T I V E S

NATURE AND PURPOSE OFSUBSIDIARY LEDGERS

Imagine a business that has several thousand charge (credit) customersand shows the transactions with these customers in only one generalledger account—Accounts Receivable. It would be nearly impossible todetermine the balance owed by an individual customer at any specifictime. Similarly, the amount payable to one creditor would be difficult to locatequickly from a single Accounts Payable account in the general ledger.

Instead, companies use subsidiary ledgers to keep track of individual balances.A subsidiary ledger is a group of accounts with a common characteristic (for example,all accounts receivable). It is an addition to, and an expansion of, the general ledger.The subsidiary ledger frees the general ledger from the details of individual balances.

Two common subsidiary ledgers are:

1. The accounts receivable (or customers’) subsidiary ledger, which collects trans-action data of individual customers.

2. The accounts payable (or creditors’) subsidiary ledger, which collects transac-tion data of individual creditors.

In each of these subsidiary ledgers, companies usually arrange individual accountsin alphabetical order.

A general ledger account summarizes the detailed data from a subsidiaryledger. For example, the detailed data from the accounts receivable subsidiaryledger are summarized in Accounts Receivable in the general ledger. The gen-eral ledger account that summarizes subsidiary ledger data is called a controlaccount. Illustration E-1 (page E2) presents an overview of the relationship of sub-sidiary ledgers to the general ledger.There, the general ledger control accounts andsubsidiary ledger accounts are in green. Note that cash and owner’s capital in this

Describe the nature and purposeof a subsidiary ledger.


illustration are not control accounts because there are no subsidiary ledger accountsrelated to these accounts.

At the end of an accounting period, each general ledger control account bal-ance must equal the composite balance of the individual accounts in the relatedsubsidiary ledger. For example, the balance in Accounts Payable in Illustration E-1must equal the total of the subsidiary balances of Creditors X � Y � Z.

E2 Appendix E Subsidiary Ledgers and Special Journals

CashGeneralLedger

Controlaccounts

SubsidiaryLedgers

AccountsReceivable

CustomerB

CustomerC

CustomerA

AccountsPayable

Common Stock

CreditorY

CreditorZ

CreditorX

Illustration E-1Relationship of generalledger and subsidiary ledgers Subsidiary Ledger Example

Illustration E-2 provides an example of a control account and subsidiary ledger forPujols Enterprises. (Due to space considerations, the explanation column in theseaccounts is not shown in this and subsequent illustrations.) Illustration E-2 is basedon the transactions listed in Illustration E-3 (next page).Illustration E-2

Relationship between gen-eral and subsidiary ledgers

File Edit View Go Bookmarks Tools Help

? Problem PostEntries Closing Reports Tools Help

General Ledger General Jrnl Sales Jrnl Cash Receipts Jrnl Purchases Jrnl

Date Ref. Debit Credit Balance

2008Jan 12

21

Branden Inc.

3,0003,000

3,000------


2008Jan 31

31

Accounts Receivable No. 112

12,0008,000

12,0004,000

The subsidiary ledgeris separate from thegeneral ledger.

Accounts Receivableis a control account.


2008Jan 20

29

Caron Co.

3,0001,000

3,0002,000


2008Jan 10

19

Aaron Co.

6,0004,000

6,0002,000

Pujols can reconcile the total debits ($12,000) and credits ($8,000) in AccountsReceivable in the general ledger to the detailed debits and credits in the subsidiaryaccounts. Also, the balance of $4,000 in the control account agrees with the total ofthe balances in the individual accounts (Aaron Co. $2,000 � Branden Inc. $0 �Caron Co. $2,000) in the subsidiary ledger.

As Illustration E-2 shows, companies make monthly postings to the control ac-counts in the general ledger.This practice allows them to prepare monthly financialstatements. Companies post to the individual accounts in the subsidiary ledgerdaily. Daily posting ensures that account information is current. This enables thecompany to monitor credit limits, bill customers, and answer inquiries from cus-tomers about their account balances.

Advantages of Subsidiary LedgersSubsidiary ledgers have several advantages:

1. They show in a single account transactions affecting one customer or one cred-itor, thus providing up-to-date information on specific account balances.

2. They free the general ledger of excessive details. As a result, a trial balance of thegeneral ledger does not contain vast numbers of individual account balances.

3. They help locate errors in individual accounts by reducing the number of ac-counts in one ledger and by using control accounts.

4. They make possible a division of labor in posting. One employee can post tothe general ledger while someone else posts to the subsidiary ledgers.

Nature and Purpose of Subsidiary Ledgers E3

Illustration E-3Sales and collectiontransactions

Credit Sales Collections on Account

Jan. 10 Aaron Co. $ 6,000 Jan. 19 Aaron Co. $ 4,00012 Branden Inc. 3,000 21 Branden Inc. 3,00020 Caron Co. 3,000 29 Caron Co. 1,000

$12,000 $ 8,000

REVIEW IT1. What is a subsidiary ledger, and what purpose does it serve?2. What is a control account, and what purpose does it serve?3. Name two general ledger accounts that may act as control accounts for a

subsidiary ledger. Can you think of a third control account?

DO ITPresented below is information related to Sims Company for its first month ofoperations. Determine the balances that appear in the accounts payable subsidiaryledger. What Accounts Payable balance appears in the general ledger at the endof January?

Action Plan■ Subtract cash paid from credit purchases to determine the balances in the

accounts payable subsidiary ledger.■ Sum the individual balances to determine the Accounts Payable balance.

Before You Go On...

Credit Purchases Cash PaidJan. 5 Devon Co. $11,000 Jan. 9 Devon Co. $7,000

11 Shelby Co. 7,000 14 Shelby Co. 2,00022 Taylor Co. 14,000 27 Taylor Co. 9,000


Solution Subsidiary ledger balances:Devon Co. $4,000 ($11,000 � $7,000)Shelby Co. $5,000 ($7,000 � $2,000)Taylor Co. $5,000 ($14,000 � $9,000).General ledger Accounts Payable balance: $14,000 ($4,000 � $5,000 � $5,000).

Related exercise material: BEE-4, BEE-5, EE-1, EE-2, EE-4, and EE-5.

SECTION 2 Expanding the Journal—Special Journals

So far you have learned to journalize transactions in a two-column generaljournal and post each entry to the general ledger.This procedure is satisfac-tory in only the very smallest companies.To expedite journalizing and post-ing, most companies use special journals in addition to the general journal.

Companies use special journals to record similar types of transactions.Examples are all sales of merchandise on account, or all cash receipts. The types oftransactions that occur frequently in a company determine what special journalsthe company uses. Most merchandising enterprises record daily transactions usingthe journals shown in Illustration E-4.

Explain how companies usespecial journals in journalizing.


Illustration E-4Use of special journals andthe general journal

SalesJournal

All sales ofmerchandiseon account

Used for:

Cash ReceiptsJournal

All cash received(including cashsales)

Used for:

PurchasesJournal

All purchasesof merchandiseon account

Used for:

Cash PaymentsJournal

All cash paid(including cashpurchases)

Used for:

GeneralJournal

Transactions thatcannot be enteredin a special journal,including correcting,adjusting, andclosing entries

Used for:

If a transaction cannot be recorded in a special journal, the company records it inthe general journal. For example, if a company had special journals for only the fourtypes of transactions listed above, it would record purchase returns and allowances inthe general journal. Similarly, correcting, adjusting, and closing entries are recordedin the general journal. In some situations, companies might use special journals otherthan those listed above. For example, when sales returns and allowances are fre-quent, a company might use a special journal to record these transactions.

Special journals permit greater division of labor because several people canrecord entries in different journals at the same time. For example, one employeemay journalize all cash receipts, and another may journalize all credit sales. Also,the use of special journals reduces the time needed to complete the postingprocess.With special journals, companies may post some accounts monthly, insteadof daily, as we will illustrate later in the chapter. On the following pages, we discussthe four special journals shown in Illustration E-4.

In the sales journal, companies record sales of merchandise on account. Cash salesof merchandise go in the cash receipts journal. Credit sales of assets other thanmerchandise go in the general journal.

Journalizing Credit SalesTo demonstrate use of a sales journal, we will use data for Karns Wholesale Supply,which uses a perpetual inventory system. Under this system, each entry in the salesjournal results in one entry at selling price and another entry at cost. The entry atselling price is a debit to Accounts Receivable (a control account) and a credit ofequal amount to Sales. The entry at cost is a debit to Cost of Goods Sold and acredit of equal amount to Merchandise Inventory (a control account). Using a salesjournal with two amount columns, the company can show on only one line a salestransaction at both selling price and cost. Illustration E-5 shows this two-columnsales journal of Karns Wholesale Supply, using assumed credit sales transactions(for sales invoices 101–107).

Sales Journal E5

SALES JOURNAL

H E L P F U L H I N TPostings are also madedaily to individual ledgeraccounts in the inventorysubsidiary ledger tomaintain a perpetualinventory.




Date Account DebitedInvoice

No.Accts. Receivable Dr.

Sales Cr.Cost of Goods Sold Dr.

Merchandise Inventory Cr.Ref.

Abbot SistersBabson Co.Carson Bros.Deli Co.Abbot SistersDeli Co.Babson Co.

2008May 3

71419212427

101102103104105106107

10,60011,3507,8009,300

15,40021,21014,57090,230

6,3607,3705,0706,510

10,78015,90010,20062,190

,,

,,

Illustration E-5Journalizing the salesjournal—perpetualinventory system

Note several points: Unlike the general journal, an explanation is not requiredfor each entry in a special journal. Also, use of prenumbered invoices ensures thatall invoices are journalized. Finally, the reference (Ref.) column is not used in jour-nalizing. It is used in posting the sales journal, as explained next.

Posting the Sales JournalCompanies make daily postings from the sales journal to the individual accountsreceivable in the subsidiary ledger. Posting to the general ledger is done monthly.Illustration E-6 (page E6) shows both the daily and monthly postings.

A check mark (✓) is inserted in the reference posting column to indicate thatthe daily posting to the customer’s account has been made. If the subsidiary ledgeraccounts were numbered, the account number would be entered in place of thecheck mark. At the end of the month, Karns posts the column totals of the sales

journal to the general ledger. Here, the column totals are as follows: From the selling-price column, a debit of $90,230 to Accounts Receivable (account No. 112), and acredit of $90,230 to Sales (account No. 401). From the cost column, a debit of$62,190 to Cost of Goods Sold (account No. 505), and a credit of $62,190 toMerchandise Inventory (account No. 120). Karns inserts the account numbers





Date Account DebitedInvoice

No.Accts. Receivable Dr.

Sales Cr.Cost of Goods Sold Dr.

Merchandise Inventory Cr.Ref.

Abbot SistersBabson Co.Carson Bros.Deli Co.Abbot SistersDeli Co.Babson Co.

2008May 3

71419212427

101102103104105106107

10,60011,3507,8009,300

15,40021,21014,57090,230

6,3607,3705,0706,510

10,78015,90010,20062,190

,,

,,

(112) / (401) (505) / (120)

Date Ref. Debit Credit Balance2008May 3y

21

Abbot Sisters

10,60015,400

10,60026,000

Date Ref. Debit Credit Balance2008May 7

27

Babson Co.

11,35014,570

11,35025,920


Carson Bros.

7,800 7,800


Accounts Receivable

90,230 90,230


24

Deli Co.

9,30021,210

9,30030,510


Sales

90,230 90,230

The company posts individualamounts to the subsidiary ledger daily.

At the end of the accounting period,the company poststotals to the generalledger.

S1S1

S1S1

S1

S1S1

S1

S1

No. 112


Merchandise Inventory

62,190162,190S1

No. 120

No. 401


Cost of Goods Sold

62,190 62,190S1

No. 505

The subsidiary ledger is separatefrom the general ledger.

Accounts Receivable is a controlaccount.

1The normal balance for Merchandise Inventory is a debit. But, because of the sequence in which we have posted the special journals,with the sales journals first, the credits to Merchandise Inventory are posted before the debits. This posting sequence explains the creditbalance in Merchandise Inventory, which exists only until the other journals are posted.

Illustration E-6Posting the sales journal

below the column totals to indicate that the postings have been made. In both thegeneral ledger and subsidiary ledger accounts, the reference S1 indicates that theposting came from page 1 of the sales journal.

Proving the LedgersThe next step is to “prove” the ledgers.To do so, Karns must determine two things:(1) The total of the general ledger debit balances must equal the total of the gen-eral ledger credit balances. (2) The sum of the subsidiary ledger balances mustequal the balance in the control account. Illustration E-7 shows the proof of thepostings from the sales journal to the general and subsidiary ledger.

Cash Receipts Journal E7

Advantages of the Sales JournalUse of a special journal to record sales on account has several advantages. First, theone-line entry for each sales transaction saves time. In the sales journal, it is not nec-essary to write out the four account titles for each transaction. Second, only totals,rather than individual entries, are posted to the general ledger. This saves postingtime and reduces the possibilities of posting errors. Finally, a division of labor re-sults, because one individual can take responsibility for the sales journal.

Illustration E-7Proving the equality of thepostings from the sales journal

Postings toGeneral Ledger

General Ledger

Credits

Debits

Debit Postings to the AccountsReceivable Subsidiary Ledger

Subsidiary Ledger

$26,00025,9207,800

30,510$90,230

Abbot SistersBabson Co.Carson Bros.Deli Co.

$62,19090,230

$152,420

$90,23062,190

$152,420

Merchandise InventorySales

Accounts ReceivableCost of Goods Sold

CASH RECEIPTS JOURNALIn the cash receipts journal, companies record all receipts of cash. The most com-mon types of cash receipts are cash sales of merchandise and collections ofaccounts receivable. Many other possibilities exist, such as receipt of money frombank loans and cash proceeds from disposal of equipment. A one- or two-columncash receipts journal would not have space enough for all possible cash receipt trans-actions.Therefore, companies use a multiple-column cash receipts journal.

Generally, a cash receipts journal includes the following columns: debit columnsfor Cash and Sales Discounts, and credit columns for Accounts Receivable, Sales, and“Other” accounts. Companies use the “Other Accounts” category when the cash re-ceipt does not involve a cash sale or a collection of accounts receivable. Under a per-petual inventory system, each sales entry also is accompanied by an entry that debitsCost of Goods Sold and credits Merchandise Inventory for the cost of the merchan-dise sold. Illustration E-8 (page E8) shows a six-column cash receipts journal.






1021

Abbot Sisters

10,600

15,400

10,600--------15,400


1727

Babson Co.

11,350

14,570

11,350--------14,570


23

Carson Bros.

7,800 7,800-------



2428

Deli Co.

9,30021,210

9,30030,51021,210

S1CR1

S1

S1CR1

S1

S1CR1

S1S1

CR1

AccountsReceivable

Cr.

SalesDiscounts

Dr.CashDr.

SalesCr.

OtherAccounts

Cr.

Cost of GoodsSold Dr.

Mdse. Inv. Cr.Ref.AccountCreditedDate

Common Stock2008Mayy 1

7101217222328

5,0001,900

10,3882,600

11,1236,0007,6449,114,

200

311

53,769,

1,900

2,600

4,500

5,000

6,000

11,000,(101) (414) (112) (401)

1,240

1,690

2,930(505)/(120)(x(( )x

10,600

11,350

7,800

9,300


Cash

53,769


31

Accounts Receivable

90,230 90,23051,180


Notes Payable

6,000


Common Stock

5,000

CR1

S1CR1

CR1

CR1

39,050

6,000

5,000

53,769


31

Sales

90,23094,730

S1CR1

90,2304,500


3162,19065,120

S1CR1

62,1902,930

Sales Discounts

No. 101

No. 112

No. 200

No. 311

No. 401

No. 414


31


62,19065,120

S1CR1

62,1902,930

No. 120

Date Ref. Debit Credit Balance2008May 31y 781 781CR1

Cost of Goods Sold No. 505


Abbot Sisters

Babson Co.Notes PayableyCarson Bros.Deli Co.

212

227

156186781

10,600

11,350

7,8009,300,

39,050,


At the end of the accounting period, thecompany posts totals to the general ledger.

Illustration E-8Journalizing and posting thecash receipts journal

Companies may use additional credit columns if these columns significantlyreduce postings to a specific account. For example, a loan company, such asHousehold International, receives thousands of cash collections from customers.Using separate credit columns for Loans Receivable and Interest Revenue, ratherthan the Other Accounts credit column, would reduce postings.

Journalizing Cash Receipts TransactionsTo illustrate the journalizing of cash receipts transactions, we will continue with theMay transactions of Karns Wholesale Supply. Collections from customers relate tothe entries recorded in the sales journal in Illustration E-5. The entries in the cashreceipts journal are based on the following cash receipts.

May 1 Stockholders invested $5,000 in the business.7 Cash sales of merchandise total $1,900 (cost, $1,240).

10 Received a check for $10,388 from Abbot Sisters in payment of invoice No. 101 for$10,600 less a 2% discount.

12 Cash sales of merchandise total $2,600 (cost, $1,690).17 Received a check for $11,123 from Babson Co. in payment of invoice No. 102 for

$11,350 less a 2% discount.22 Received cash by signing a note for $6,000.23 Received a check for $7,644 from Carson Bros. in full for invoice No. 103 for $7,800

less a 2% discount.28 Received a check for $9,114 from Deli Co. in full for invoice No. 104 for $9,300 less a

2% discount.

Further information about the columns in the cash receipts journal is listed below.

Debit Columns:1. Cash. Karns enters in this column the amount of cash actually received in each

transaction. The column total indicates the total cash receipts for the month.2. Sales Discounts. Karns includes a Sales Discounts column in its cash receipts

journal. By doing so, it does not need to enter sales discount items in the gen-eral journal. As a result, the cash receipts journal shows on one line the collec-tion of an account receivable within the discount period.

Credit Columns:3. Accounts Receivable. Karns uses the Accounts Receivable column to record

cash collections on account. The amount entered here is the amount to becredited to the individual customer’s account.

4. Sales. The Sales column records all cash sales of merchandise. Cash sales ofother assets (plant assets, for example) are not reported in this column.

5. Other Accounts. Karns uses the Other Accounts column whenever the credit isother than to Accounts Receivable or Sales. For example, in the first entry,Karns enters $5,000 as a credit to Common Stock.This column is often referredto as the sundry accounts column.

Debit and Credit Column:6. Cost of Goods Sold and Merchandise Inventory. This column records debits to

Cost of Goods Sold and credits to Merchandise Inventory.

In a multi-column journal, generally only one line is needed for each entry.Debit and credit amounts for each line must be equal. When Karns journalizes thecollection from Abbot Sisters on May 10, for example, three amounts are indicated.Note also that the Account Credited column identifies both general ledger andsubsidiary ledger account titles. General ledger accounts are illustrated in the May 1

Cash Receipts Journal E9

H E L P F U L H I N TWhen is an account titleentered in the “AccountCredited” column of thecash receipts journal?Answer: A subsidiaryledger account is enteredwhen the entry involves acollection of accounts receivable. A generalledger account is enteredwhen the account is notshown in a specialcolumn (and an amountmust be entered in theOther Accounts column).Otherwise, no account isshown in the “AccountCredited” column.

and May 22 entries. A subsidiary account is illustrated in the May 10 entry for thecollection from Abbot Sisters.

When Karns has finished journalizing a multi-column journal, it totals theamount columns and compares the totals to prove the equality of debits andcredits. Illustration E-9 shows the proof of the equality of Karns’s cash receiptsjournal.


Illustration E-9Proving the equality of thecash receipts journal Debits Credits

$39,0504,500

11,0002,930

$57,480

Accounts ReceivableSalesOther AccountsMerchandise Inventory

$53,769781

2,930$57,480

CashSales DiscountsCost of Goods Sold

Totaling the columns of a journal and proving the equality of the totals is calledfooting and cross-footing a journal.

Posting the Cash Receipts JournalPosting a multi-column journal involves the following steps.

1. At the end of the month, the company posts all column totals, exceptfor the Other Accounts total, to the account title(s) specified in thecolumn heading (such as Cash or Accounts Receivable). The companythen enters account numbers below the column totals to show that

they have been posted. For example, Karns has posted cash to account No. 101,accounts receivable to account No. 112, merchandise inventory to accountNo. 120, sales to account No. 401, sales discounts to account No. 414, and cost ofgoods sold to account No. 505.

2. The company separately posts the individual amounts comprising theOther Accounts total to the general ledger accounts specified in theAccount Credited column. See, for example, the credit posting to CommonStock: The total amount of this column has not been posted. The symbol (X) isinserted below the total to this column to indicate that the amount has notbeen posted.

3. The individual amounts in a column, posted in total to a control account(Accounts Receivable, in this case), are posted daily to the subsidiary ledgeraccount specified in the Account Credited column. See, for example, the creditposting of $10,600 to Abbot Sisters.

The symbol CR, used in both the subsidiary and general ledgers, identifies postingsfrom the cash receipts journal.

Proving the LedgersAfter posting of the cash receipts journal is completed, Karns proves the ledgers.As shown in Illustration E-10 (next page), the general ledger totals agree.Also, thesum of the subsidiary ledger balances equals the control account balance.

Indicate how companies post amulti-column journal.


In the purchases journal, companies record all purchases of merchandise on ac-count. Each entry in this journal results in a debit to Merchandise Inventory and acredit to Accounts Payable. Illustration E-11 (page E12) shows the purchases jour-nal for Karns Wholesale Supply.

When using a one-column purchases journal (as in Illustration E-11), a com-pany cannot journalize other types of purchases on account or cash purchases in it.For example, using the purchases journal shown in Illustration E-11, Karns wouldhave to record credit purchases of equipment or supplies in the general journal.Likewise, all cash purchases would be entered in the cash payments journal. As il-lustrated later, companies that make numerous credit purchases for items otherthan merchandise often expand the purchases journal to a multi-column format.(See Illustration E-14 on page E13.)

Journalizing Credit Purchases of MerchandiseThe journalizing procedure is similar to that for a sales journal. Companies makeentries in the purchases journal from purchase invoices. In contrast to the salesjournal, the purchases journal may not have an invoice number column, becauseinvoices received from different suppliers will not be in numerical sequence.To en-sure that they record all purchase invoices, some companies consecutively numbereach invoice upon receipt and then use an internal document number column inthe purchases journal. The entries for Karns Wholesale Supply are based on theassumed credit purchases listed in Illustration E-12 (page E12).

Posting the Purchases JournalThe procedures for posting the purchases journal are similar to those for the salesjournal. In this case, Karns makes daily postings to the accounts payable ledger; itmakes monthly postings to Merchandise Inventory and Accounts Payable in thegeneral ledger. In both ledgers, Karns uses P1 in the reference column to show thatthe postings are from page 1 of the purchases journal.

Proof of the equality of the postings from the purchases journal to both ledgersis shown in Illustration E-13 (page E13).

Purchases Journal E11

PURCHASES JOURNAL

Illustration E-10Proving the ledgers afterposting the sales and thecash receipts journals

$53,76951,180

78165,120

$170,850

CashAccounts ReceivableSales DiscountsCost of Goods Sold

$15,40014,57021,210

$51,180

Abbot SistersBabson Co.Deli Co.

Accounts Receivable Subsidiary Ledger General Ledger

$ 6,0005,000

94,73065,120

$170,850

Notes PayableCommon Stock SalesMerchandise Inventory

Credits

Debits

H E L P F U L H I N TPostings to subsidiaryledger accounts are donedaily because it is oftennecessary to know a current balance for thesubsidiary accounts.




2008May 10

29

Eaton and Howe Inc.

7,20012,600

7,20019,800


2008May 14

26

Fabor and Son

6,9008,700

6,90015,600


2008May 6

19

Jasper Manufacturing Inc.

11,00028,500

P1P1

P1P1

P1P1

11,00017,500

At the end of theaccounting period,the company poststotals to the generalledger.


2008

Accounts Payable

63,900 63,900


2008May 31

3131


63,900

62,19065,1201,220

62,1902,930

Date Account Credited

MerchandiseInventory Dr.

Accounts Payable Cr.Ref.2008

61014192629

2/10, n/303/10, n/301/10, n/302/10, n/301/10, n/303/10, n/30

11,0007,2006,900

17,5008,700

12,60063,900

P1

S1CR1

P1

No. 201

No. 120

Terms

(120)/(201)


Accounts Payableis a control account.

Jasper Manufacturing Inc.J p gEaton and Howe Inc.Fabor and SonJasper Manufacturing Inc.J p gFabor and SonEaton and Howe Inc.

Mayy

,

May 31y




Illustration E-11Journalizing and posting thepurchases journal

Illustration E-12Credit purchasestransactions

Date Supplier Amount5/6 Jasper Manufacturing Inc. $11,000

5/10 Eaton and Howe Inc. 7,2005/14 Fabor and Son 6,9005/19 Jasper Manufacturing Inc. 17,5005/26 Fabor and Son 8,7005/29 Eaton and Howe Inc. 12,600

Illustration E-13Proving the equality of thepurchases journal

Postings toGeneral Ledger

Credit Postings toAccounts Payable Ledger

$19,80015,60028,500

$63,900

Eaton and Howe Inc.Fabor and SonJasper Manufacturing Inc.

$63,900

$63,900

Merchandise Inventory (debit)

Accounts Payable (credit)

In a cash payments (cash disbursements) journal, companies record all disburse-ments of cash. Entries are made from prenumbered checks. Because companiesmake cash payments for various purposes, the cash payments journal has multiplecolumns. Illustration E-15 (page E14) shows a four-column journal.

Journalizing Cash Payments TransactionsThe procedures for journalizing transactions in this journal are similar to those forthe cash receipts journal. Karns records each transaction on one line, and for eachline there must be equal debit and credit amounts.The entries in the cash payments

Cash Payments Journal E13

Expanding the Purchases JournalAs noted earlier, some companies expand the purchases journal to include all typesof purchases on account. Instead of one column for merchandise inventory andaccounts payable, they use a multiple-column format. This format usually includes acredit column for Accounts Payable and debit columns for purchases of MerchandiseInventory, Office Supplies, Store Supplies, and Other Accounts. Illustration E-14shows a multi-column purchases journal for Hanover Co.The posting procedures aresimilar to those shown earlier for posting the cash receipts journal.

CASH PAYMENTS JOURNAL

H E L P F U L H I N TA single-column purchasesjournal needs only to befooted to prove theequality of debits andcredits.

Illustration E-14Multi-column purchasesjournal




Date Account Credited

AccountsPayable

Cr.

2008June 1

35

30

2,0001,5002,600

80056,600

8001,200 4,900

2,000

MerchandiseInventory

Dr.

OfficeSupplies

Dr.

StoreSupplies

Dr.

Other AccountsDr.

Account Ref. Amount

Equipment 157 2,6001,500

Ref.

Signe AudiogWight Co.gOrange Tree Co.

Sue's Business Forms7,50043,000





At the end of the accounting period, the company posts totals to the general ledger.





2008May 10

1929

Eaton and Howe Inc.

7,200

12,600

7,200-------

12,600


2008May 14

2326

Fabor and Son

6,900

8,700

6,900-------8,700


2008May 6

101928

Jasper Manufacturing Inc.

11,000--------17,500--------


2008May 31

31

Accounts Payable

42,60063,90021,300

101102103104105106107108

2008May 1

38

1019232830

130120120

332

1,200100

4,40010,7806,9846,831

17,150500

47,945

P1CP1

P1

P1CP1

P1

P1CP1

P1CP1

P1CP1


2008May 31

31

Cash

47,94553,7695,824

CR1CP1

No. 101

No. 201

11,000

17,500

(x(( )x

DateCk.No. Account Debited Ref.

Other Accounts Dr.

AccountsPayable Dr.

MerchandiseInventory Cr.

CashCr.

1,200100

4,400

5006,200

11,0007,2006,900

17,500

42,600

22021669

350

855

(201) (120) (101)

7,200

6,900

11,000

17,500


2008May 3

831313131


62,1902,930

855

1004,500

57,69060,6203,2802,425

CPICPI

SICRI

PlCPI

1004,400

63,900

No. 120


2008May 1

Prepaid Insurance

1,200 1,200CP1

No. 130


2008May 30

Dividends

500 500CP1

No. 332

53,769

63,900

Prepaid InsurancepMdse. InventoryyMdse. InventoryyJasper Manuf. Inc.Eaton & Howe Inc.Fabor and SonJasper Manuf. Inc.J pDividends

Illustration E-15Journalizing and posting thecash payments journal

journal in Illustration E-15 are based on the following transactions for KarnsWholesale Supply.

May 1 Issued check No. 101 for $1,200 for the annual premium on a fire insurance policy.3 Issued check No. 102 for $100 in payment of freight when terms were FOB shipping

point.8 Issued check No. 103 for $4,400 for the purchase of merchandise.

10 Sent check No. 104 for $10,780 to Jasper Manufacturing Inc. in payment of May 6 in-voice for $11,000 less a 2% discount.

19 Mailed check No. 105 for $6,984 to Eaton and Howe Inc. in payment of May 10invoice for $7,200 less a 3% discount.

23 Sent check No. 106 for $6,831 to Fabor and Son in payment of May 14 invoice for$6,900 less a 1% discount.

28 Sent check No. 107 for $17,150 to Jasper Manufacturing Inc. in payment of May 19invoice for $17,500 less a 2% discount.

30 Issued check No. 108 for $500 to stockholders as a dividend.

Note that whenever Karns enters an amount in the Other Accounts column, it mustidentify a specific general ledger account in the Account Debited column.The entriesfor checks No. 101, 102, 103, and 108 illustrate this situation. Similarly, Karns mustidentify a subsidiary account in the Account Debited column whenever it enters anamount in the Accounts Payable column.See, for example, the entry for check No.104.

After Karns journalizes the cash payments journal, it totals the columns. Thetotals are then balanced to prove the equality of debits and credits.

Posting the Cash Payments JournalThe procedures for posting the cash payments journal are similar to those for thecash receipts journal. Karns posts the amounts recorded in the Accounts Payable col-umn individually to the subsidiary ledger and in total to the control account. It postsMerchandise Inventory and Cash only in total at the end of the month.Transactionsin the Other Accounts column are posted individually to the appropriate account(s)affected.The company does not post totals for the Other Accounts column.

Illustration E-15 shows the posting of the cash payments journal. Note that Karnsuses the symbol CP as the posting reference.After postings are completed, the com-pany proves the equality of the debit and credit balances in the general ledger. In ad-dition, the control account balances should agree with the subsidiary ledger total bal-ance. Illustration E-16 shows the agreement of these balances.

Cash Payments Journal E15

5,82451,1802,4251,200

500781

65,120$127,030

CashAccounts ReceivableMerchandise InventoryPrepaid InsuranceDividendsSales DiscountsCost of Goods Sold

$12,6008,700

$21,300

Eaton and Howe Inc.Fabor and Son

Accounts Payable Subsidiary Ledger General LedgerDebits

6,00021,3005,000

94,730$127,030

Notes PayableAccounts PayableCommon StockSales

Credits

$

$

Illustration E-16Proving the ledgers afterpostings from the sales,cash receipts, purchases,and cash payments journals

Special journals for sales, purchases, and cash substantially reduce the number ofentries that companies make in the general journal. Only transactions that cannotbe entered in a special journal are recorded in the general journal. For example, acompany may use the general journal to record such transactions as granting ofcredit to a customer for a sales return or allowance, granting of credit from a sup-plier for purchases returned, acceptance of a note receivable from a customer, andpurchase of equipment by issuing a note payable. Also, correcting, adjusting, andclosing entries are made in the general journal.

The general journal has columns for date, account title and explanation, refer-ence, and debit and credit amounts. When control and subsidiary accounts are notinvolved, the procedures for journalizing and posting of transactions are the sameas those described in earlier chapters.When control and subsidiary accounts are in-volved, companies make two changes from the earlier procedures:

1. In journalizing, they identify both the control and the subsidiary accounts.2. In posting, there must be a dual posting: once to the control account and once

to the subsidiary account.


EFFECTS OF SPECIAL JOURNALSON THE GENERAL JOURNAL





2008May 14

232631

Fabor and Son

6,900

8,700

6,900-------8,7008,200


2008May 31

3131

Accounts Payable

63,900 63,90021,300

20,800


2008May 31


500 500

Date Account Title and Explanation Ref.

Accounts Payable–Fabor and Son Merchandise Inventory (Received credit for returned goods)

2008May 31 500

P1CP1

P1G1

P1CP1G1

G1

No. 201

No. 120

CreditDebit

500201/120

6,900

500

42,600500

,

Illustration E-17Journalizing and posting thegeneral journal

To illustrate, assume that on May 31, Karns Wholesale Supply returns $500 ofmerchandise for credit to Fabor and Son. Illustration E-17 shows the entry in thegeneral journal and the posting of the entry. Note that if Karns receives cashinstead of credit on this return, then it would record the transaction in the cashreceipts journal.

Note that the general journal indicates two accounts (Accounts Payable, andFabor and Son) for the debit, and two postings (“201/✓”) in the reference column.One debit is posted to the control account and another debit to the creditor’saccount in the subsidiary ledger.

Effects of Special Journals on the General Journal E17

REVIEW IT1. What types of special journals do companies frequently use to record trans-

actions? Why do they use special journals?2. Explain how companies post transactions recorded in the sales journal and

the cash receipts journal.3. Indicate the types of transactions that companies record in the general jour-

nal when they use special journals.

Before You Go On...

Demonstration Problem

Cassandra Wilson Company uses a six-column cash receipts journal with the followingcolumns:

July 3 Cash sales total $5,800 (cost, $3,480).5 Received a check for $6,370 from Jeltz Company in payment of an invoice dated

June 26 for $6,500, terms 2/10, n/30.9 Stockholders made an additional investment of $5,000 cash in the business.

10 Cash sales total $12,519 (cost, $7,511).12 Received a check for $7,275 from R. Eliot & Co. in payment of a $7,500 invoice

dated July 3, terms 3/10, n/30.15 Received a customer advance of $700 cash for future sales.20 Cash sales total $15,472 (cost, $9,283).22 Received a check for $5,880 from Beck Company in payment of $6,000 invoice

dated July 13, terms 2/10, n/30.29 Cash sales total $17,660 (cost, $10,596).31 Received cash of $200 on interest earned for July.

Instructions(a) Journalize the transactions in the cash receipts journal.(b) Contrast the posting of the Accounts Receivable and Other Accounts columns.

Cash (Dr.)Sales Discounts (Dr.)Accounts Receivable (Cr.)Sales (Cr.)

Cash receipts transactions for the month of July 2008 are as follows.

Other Accounts (Cr.)Cost of Goods Sold (Dr.) and

Merchandise Inventory (Cr.)

action plan✔ Record all cash receipts inthe cash receipts journal.

✔ The “account credited”indicates items posted indi-vidually to the subsidiaryledger or general ledger.

✔ Record cash sales in thecash receipts journal—notin the sales journal.

✔ The total debits mustequal the total credits.

1 Describe the nature and purpose of a subsidiaryledger. A subsidiary ledger is a group of accounts with acommon characteristic. It facilitates the recording process byfreeing the general ledger from details of individual balances.

2 Explain how companies use special journals in journal-izing. Companies use special journals to group similartypes of transactions. In a special journal, generally onlyone line is used to record a complete transaction.

3 Indicate how companies post a multi-column journal.In posting a multi-column journal:(a) Companies post all column totals except for the Other

Accounts column once at the end of the month to theaccount title specified in the column heading.

(b) Companies do not post the total of the Other Accountscolumn. Instead, the individual amounts comprisingthe total are posted separately to the general ledgeraccounts specified in the Account Credited (Debited)column.

(c) The individual amounts in a column posted in total to acontrol account are posted daily to the subsidiary ledgeraccounts specified in the Account Credited (Debited)column.

Accounts payable (creditors’) subsidiary ledger A sub-sidiary ledger that collects transaction data of individualcreditors. (p. E1).

Accounts receivable (customers’) subsidiary ledger Asubsidiary ledger that collects transaction data of individualcustomers. (p. E1).

Cash payments (disbursements) journal A special journalthat records all cash paid. (p. E13).

Cash receipts journal A special journal that records allcash received. (p. E7).

Control account An account in the general ledger that sum-marizes subsidiary ledger. (p. E1).


Solution(a) CASSANDRA WILSON COMPANY

Cash Receipts Journal CR1

(b) The Accounts Receivable column is posted as a credit to Accounts Receivable. Theindividual amounts are credited to the customers’ accounts identified in the AccountCredited column, which are maintained in the accounts receivable subsidiary ledger.

The amounts in the Other Accounts column are posted individually. They are cred-ited to the account titles identified in the Account Credited column.

Sales Accounts Other Cost of GoodsCash Discounts Receivable Sales Accounts Sold Dr.

Date Account Credited Ref. Dr. Dr. Cr. Cr. Cr. Mdse. Inv. Cr.

20087/3 5,800 5,800 3,480

5 Jeltz Company 6,370 130 6,5009 Common Stock 5,000 5,000

10 12,519 12,519 7,51112 R. Eliot & Co. 7,275 225 7,50015 Unearned Revenue 700 70020 15,472 15,472 9,28322 Beck Company 5,880 120 6,00029 17,660 17,660 10,59631 Interest Revenue 200 200

76,876 475 20,000 51,451 5,900 30,870

SUMMARY OF STUDY OBJECTIVES

GLOSSARY

Questions E19

Purchases journal A special journal that records all pur-chases of merchandise on account. (p. E11).

Sales journal A special journal that records all sales of mer-chandise on account. (p. E5).

Special journal A journal that records similar types oftransactions, such as all credit sales. (p. E4).

Subsidiary ledger A group of accounts with a commoncharacteristic. (p. E1).

1. What are the advantages of using subsidiary ledgers?2. (a) When do companies normally post to (1) the sub-

sidiary accounts and (2) the general ledger control ac-counts? (b) Describe the relationship between a controlaccount and a subsidiary ledger.

3. Identify and explain the four special journals discussed inthe chapter. List an advantage of using each of these jour-nals rather than using only a general journal.

4. Thogmartin Company uses special journals. It recorded ina sales journal a sale made on account to R. Peters for$435.A few days later, R. Peters returns $70 worth of mer-chandise for credit. Where should Thogmartin Companyrecord the sales return? Why?

5. A $500 purchase of merchandise on account from LoreCompany was properly recorded in the purchases journal.When posted, however, the amount recorded in the

Answers are at the end of the chapter.

1. Which of the following is incorrect concerning subsidiaryledgers?a. The purchases ledger is a common subsidiary ledger for

creditor accounts.b. The accounts receivable ledger is a subsidiary ledger.c. A subsidiary ledger is a group of accounts with a com-

mon characteristic.d. An advantage of the subsidiary ledger is that it permits

a division of labor in posting.2. A sales journal will be used for:

Credit Cash SalesSales Sales Discounts

a. no yes yesb. yes no yesc. yes no nod. yes yes no

3. Which of the following statements is correct?a. The sales discount column is included in the cash re-

ceipts journal.b. The purchases journal records all purchases of mer-

chandise whether for cash or on account.c. The cash receipts journal records sales on account.d. Merchandise returned by the buyer is recorded by the

seller in the purchases journal.4. Which of the following is incorrect concerning the posting

of the cash receipts journal?a. The total of the Other Accounts column is not posted.b. All column totals except the total for the Other

Accounts column are posted once at the end of themonth to the account title(s) specified in the columnheading.

c. The totals of all columns are posted daily to theaccounts specified in the column heading.

d. The individual amounts in a column posted in totalto a control account are posted daily to the subsidiary

ledger account specified in the Account Creditedcolumn.

5. Postings from the purchases journal to the subsidiaryledger are generally made:a. yearly.b. monthly.c. weekly.d. daily.

6. Which statement is incorrect regarding the general journal?a. Only transactions that cannot be entered in a special

journal are recorded in the general journal.b. Dual postings are always required in the general journal.c. The general journal may be used to record accept-

ance of a note receivable in payment of an accountreceivable.

d. Correcting, adjusting, and closing entries are made inthe general journal.

7. When companies use special journals:a. they record all purchase transactions in the purchases

journal.b. they record all cash received, except from cash sales, in

the cash receipts journal.c. they record all cash disbursements in the cash pay-

ments journal.d. a general journal is not necessary.

8. If a customer returns goods for credit, the selling companynormally makes an entry in the:a. cash payments journal.b. sales journal.c. general journal.d. cash receipts journal.


SELF-STUDY QUESTIONS

(SO 1)

(SO 2)

(SO 2, 3)

(SO 3)

(SO 3)

(SO 2)

(SO 2)

(SO 2)

QUESTIONS


subsidiary ledger was $50. How might this error bediscovered?

6. Why would special journals used in different businessesnot be identical in format? What type of business wouldmaintain a cash receipts journal but not include a columnfor accounts receivable?

7. The cash and the accounts receivable columns in the cashreceipts journal were mistakenly overadded by $4,000 atthe end of the month. (a) Will the customers’ ledger agreewith the Accounts Receivable control account? (b)Assuming no other errors, will the trial balance totals beequal?

8. One column total of a special journal is posted at month-end to only two general ledger accounts. One of these twoaccounts is Accounts Receivable. What is the name of thisspecial journal? What is the other general ledger accountto which that same month-end total is posted?

9. In what journal would the following transactions berecorded? (Assume that a two-column sales journal and asingle-column purchases journal are used.)(a) Recording of depreciation expense for the year.(b) Credit given to a customer for merchandise purchased

on credit and returned.(c) Sales of merchandise for cash.

(d) Sales of merchandise on account.(e) Collection of cash on account from a customer.(f) Purchase of office supplies on account.

10. In what journal would the following transactions berecorded? (Assume that a two-column sales journal and asingle-column purchases journal are used.)(a) Cash received from signing a note payable.(b) Investment of cash by stockholders.(c) Closing of the expense accounts at the end of the year.(d) Purchase of merchandise on account.(e) Credit received for merchandise purchased and

returned to supplier.(f) Payment of cash on account due a supplier.

11. What transactions might be included in a multiple-columnpurchases journal that would not be included in a single-column purchases journal?

12. Give an example of a transaction in the general journalthat causes an entry to be posted twice (i.e., to two ac-counts), one in the general ledger, the other in the sub-sidiary ledger. Does this affect the debit/credit equality ofthe general ledger?

13. Give some examples of appropriate general journal trans-actions for an organization using special journals.

BEE-1 Presented below is information related to Kienholz Company for its first month of op-erations. Identify the balances that appear in the accounts receivable subsidiary ledger and theaccounts receivable balance that appears in the general ledger at the end of January.

BRIEF EXERCISES

BEE-2 Identify in what ledger (general or subsidiary) each of the following accounts is shown.

1. Rent Expense 3. Notes Payable2. Accounts Receivable—Char 4. Accounts Payable—Thebeau

BEE-3 Identify the journal in which each of the following transactions is recorded.

1. Cash sales 4. Credit sales2. Payment of dividends 5. Purchase of merchandise on account3. Cash purchase of land 6. Receipt of cash for services performed

BEE-4 Indicate whether each of the following debits and credits is included in the cash receiptsjournal. (Use “Yes” or “No” to answer this question.)

1. Debit to Sales 3. Credit to Accounts Receivable2. Credit to Merchandise Inventory 4. Debit to Accounts Payable

BEE-5 Galindo Co. uses special journals and a general journal. Identify the journal in whicheach of the following transactions is recorded.

(a) Purchased equipment on account.(b) Purchased merchandise on account.(c) Paid utility expense in cash.(d) Sold merchandise on account.

Credit Sales Cash CollectionsJan. 7 Agler Co. $10,000 Jan. 17 Agler Co. $7,000

15 Barto Co. 6,000 24 Barto Co. 4,00023 Maris Co. 9,000 29 Maris Co. 9,000

Identify subsidiary ledgerbalances.

(SO 1)

Identify subsidiary ledgeraccounts.

(SO 1)

Identify special journals.

(SO 2)

Identify entries to cash receiptsjournal.

(SO 2)

Identify transactions for special journals.

(SO 2)

BEE-6 Identify the special journal(s) in which the following column headings appear.

1. Sales Discounts Dr. 4. Sales Cr.2. Accounts Receivable Cr. 5. Merchandise Inventory Dr.3. Cash Dr.

BEE-7 Kidwell Computer Components Inc. uses a multi-column cash receipts journal. Indicatewhich column(s) is/are posted only in total, only daily, or both in total and daily.

1. Accounts Receivable 3. Cash2. Sales Discounts 4. Other Accounts

Exercises E21

Indicate postings to cashreceipts journal.

(SO 3)

Identify transactions for special journals.

(SO 2)

EXERCISESEE-1 Donahue Company uses both special journals and a general journal as described in thischapter. On June 30, after all monthly postings had been completed, the Accounts Receivablecontrol account in the general ledger had a debit balance of $320,000; the Accounts Payable con-trol account had a credit balance of $77,000.

The July transactions recorded in the special journals are summarized below. No entries af-fecting accounts receivable and accounts payable were recorded in the general journal for July.

Sales journal Total sales $161,400Purchases journal Total purchases $56,400Cash receipts journal Accounts receivable column total $131,000Cash payments journal Accounts payable column total $47,500

Instructions(a) What is the balance of the Accounts Receivable control account after the monthly postings

on July 31?(b) What is the balance of the Accounts Payable control account after the monthly postings on

July 31?(c) To what account(s) is the column total of $161,400 in the sales journal posted?(d) To what account(s) is the accounts receivable column total of $131,000 in the cash receipts

journal posted?

EE-2 Presented below is the subsidiary accounts receivable account of Jeremy Dody.

Date Ref. Debit Credit Balance2008Sept. 2 S31 61,000 61,000

9 G4 14,000 47,00027 CR8 47,000 —

InstructionsWrite a memo to Andrea Barden, chief financial officer, that explains each transaction.

EE-3 On September 1 the balance of the Accounts Receivable control account in the generalledger of Seaver Company was $10,960.The customers’ subsidiary ledger contained account bal-ances as follows: Ruiz $1,440, Kingston $2,640, Bannister $2,060, Crampton $4,820. At the end ofSeptember the various journals contained the following information.

Sales journal: Sales to Crampton $800; to Ruiz $1,260; to Iman $1,330; to Bannister $1,100.Cash receipts journal: Cash received from Bannister $1,310; from Crampton $2,300; from Iman$380; from Kingston $1,800; from Ruiz $1,240.General journal: An allowance is granted to Crampton $220.

Instructions(a) Set up control and subsidiary accounts and enter the beginning balances. Do not construct

the journals.(b) Post the various journals. Post the items as individual items or as totals, whichever would be

the appropriate procedure. (No sales discounts given.)

Determine control accountbalances, and explain postingof special journals.

(SO 1, 3)

Explain postings to subsidiaryledger.

(SO 1)

Post various journals to control and subsidiaryaccounts.

(SO 1, 3)

(c) Prepare a list of customers and prove the agreement of the controlling account with thesubsidiary ledger at September 30, 2008.

EE-4 Yu Suzuki Company has a balance in its Accounts Receivable control account of $11,000on January 1, 2008. The subsidiary ledger contains three accounts: Smith Company, balance$4,000; Green Company, balance $2,500; and Koyan Company. During January, the followingreceivable-related transactions occurred.

Credit Sales Collections ReturnsSmith Company $9,000 $8,000 $ -0-Green Company 7,000 2,500 3,000Koyan Company 8,500 9,000 -0-

Instructions(a) What is the January 1 balance in the Koyan Company subsidiary account?(b) What is the January 31 balance in the control account?(c) Compute the balances in the subsidiary accounts at the end of the month.(d) Which January transaction would not be recorded in a special journal?

EE-5 Nobo Uematsu Company has a balance in its Accounts Payable control account of$8,250 on January 1, 2008. The subsidiary ledger contains three accounts: Jones Company, bal-ance $3,000; Brown Company, balance $1,875; and Aatski Company. During January, the follow-ing receivable-related transactions occurred.

Purchases Payments ReturnsJones Company $6,750 $6,000 $ -0-Brown Company 5,250 1,875 2,250Aatski Company 6,375 6,750 -0-

Instructions(a) What is the January 1 balance in the Aatski Company subsidiary account?(b) What is the January 31 balance in the control account?(c) Compute the balances in the subsidiary accounts at the end of the month.(d) Which January transaction would not be recorded in a special journal?

EE-6 Montalvo Company uses special journals and a general journal. The following transac-tions occurred during September 2008.

Sept. 2 Sold merchandise on account to T. Hossfeld, invoice no. 101, $720, terms n/30.The costof the merchandise sold was $420.

10 Purchased merchandise on account from L. Rincon $600, terms 2/10, n/30.12 Purchased office equipment on account from R. Press $6,500.21 Sold merchandise on account to P. Lowther, invoice no. 102 for $800, terms 2/10, n/30.

The cost of the merchandise sold was $480.25 Purchased merchandise on account from W. Barone $860, terms n/30.27 Sold merchandise to S. Miller for $700 cash. The cost of the merchandise sold was

$400.

Instructions(a) Prepare a sales journal (see Illustration E-6) and a single-column purchase journal (see

Illustration E-11). (Use page 1 for each journal.)(b) Record the transaction(s) for September that should be journalized in the sales journal and

the purchases journal.

EE-7 Pherigo Co. uses special journals and a general journal. The following transactions oc-curred during May 2008.

May 1 I. Pherigo invested $50,000 cash in the business in exchange for common stock.2 Sold merchandise to B. Sherrick for $6,300 cash. The cost of the merchandise sold was

$4,200.3 Purchased merchandise for $7,200 from J. DeLeon using check no. 101.

14 Paid salary to H. Potter $700 by issuing check no. 102.


Determine control andsubsidiary ledger balances for accounts receivable.

(SO 1)

Determine control andsubsidiary ledger balances for accounts payable.

(SO 1)

Record transactions in salesand purchases journal.

(SO 1, 2)

Record transactions in cash receipts and cash paymentsjournal.

(SO 1, 2)

16 Sold merchandise on account to K. Kimbell for $900, terms n/30. The cost of the mer-chandise sold was $630.

22 A check of $9,000 is received from M. Moody in full for invoice 101; no discountgiven.

Instructions(a) Prepare a multiple-column cash receipts journal (see Illustration E-8) and a multiple-

column cash payments journal (see Illustration E-15). (Use page 1 for each journal.)(b) Record the transaction(s) for May that should be journalized in the cash receipts journal

and cash payments journal.

EE-8 Wick Company uses the columnar cash journals illustrated in the textbook. In April, thefollowing selected cash transactions occurred.

1. Made a refund to a customer for the return of damaged goods.2. Received collection from customer within the 3% discount period.3. Purchased merchandise for cash.4. Paid a creditor within the 3% discount period.5. Received collection from customer after the 3% discount period had expired.6. Paid freight on merchandise purchased.7. Paid cash for office equipment.8. Received cash refund from supplier for merchandise returned.9. Paid cash dividend to stockholders.

10. Made cash sales.

InstructionsIndicate (a) the journal, and (b) the columns in the journal that should be used in recording eachtransaction.

EE-9 Velasquez Company has the following selected transactions during March.

Mar. 2 Purchased equipment costing $9,400 from Chang Company on account.5 Received credit of $410 from Lyden Company for merchandise damaged in ship-

ment to Velasquez.7 Issued credit of $400 to Higley Company for merchandise the customer returned.

The returned merchandise had a cost of $260.

Velasquez Company uses a one-column purchases journal, a sales journal, the columnar cashjournals used in the text, and a general journal.

Instructions(a) Journalize the transactions in the general journal.(b) In a brief memo to the president of Velasquez Company, explain the postings to

the control and subsidiary accounts from each type of journal.

EE-10 Below are some typical transactions incurred by Kwun Company.

1. Payment of creditors on account.2. Return of merchandise sold for credit.3. Collection on account from customers.4. Sale of land for cash.5. Sale of merchandise on account.6. Sale of merchandise for cash.7. Received credit for merchandise purchased on credit.8. Sales discount taken on goods sold.9. Payment of employee wages.

10. Payment of cash dividend to stockholders.11. Depreciation on building.12. Purchase of office supplies for cash.13. Purchase of merchandise on account.

InstructionsFor each transaction, indicate whether it would normally be recorded in a cash receipts journal,cash payments journal, sales journal, single-column purchases journal, or general journal.

Exercises E23

Explain journalizing in cashjournals.

(SO 2)

Journalize transactions ingeneral journal and post.

(SO 1, 3)

Indicate journalizing in specialjournals.

(SO 2)

EE-11 The general ledger of Sanchez Company contained the following Accounts Payablecontrol account (in T-account form). Also shown is the related subsidiary ledger.


GENERAL LEDGER

Accounts PayableFeb. 15 General journal 1,400 Feb. 1 Balance 26,025

28 ? ? 5 General journal 26511 General journal 55028 Purchases 13,400

Feb. 28 Balance 9,500

ACCOUNTS PAYABLE LEDGER

Perez TebbettsFeb. 28 Bal. 4,600 Feb. 28 Bal. ?

ZerbeFeb. 28 Bal. 2,300

Instructions(a) Indicate the missing posting reference and amount in the control account, and the missing

ending balance in the subsidiary ledger.(b) Indicate the amounts in the control account that were dual-posted (i.e., posted to the

control account and the subsidiary accounts).

EE-12 Selected accounts from the ledgers of Lockhart Company at July 31 showed thefollowing.

Store Equipment No. 153

Date Explanation Ref. Debit Credit Balance

July 1 G1 3,900 3,900

Accounts Payable No. 201


July 1 G1 3,900 3,90015 G1 400 4,30018 G1 100 4,20025 G1 200 4,00031 P1 8,300 12,300

Merchandise Inventory No. 120


July 15 G1 400 40018 G1 100 30025 G1 200 10031 P1 8,300 8,400

GENERAL LEDGER

Drago Co.Date Explanation Ref. Debit Credit Balance

July 14 P1 1,100 1,10025 G1 200 900

Erik Co.Date Explanation Ref. Debit Credit Balance

July 12 P1 500 50021 P1 600 1,100

Heinen Inc.Date Explanation Ref. Debit Credit Balance

July 15 G1 400 400

Albin Equipment Co.Date Explanation Ref. Debit Credit Balance

July 1 G1 3,900 3,900

Brian Co.Date Explanation Ref. Debit Credit Balance

July 3 P1 2,400 2,40020 P1 700 3,100

Chacon CorpDate Explanation Ref. Debit Credit Balance

July 17 P1 1,400 1,40018 G1 100 1,30029 P1 1,600 2,900

ACCOUNTS PAYABLE LEDGER

Explain posting to controlaccount and subsidiary ledger.

(SO 1, 3)

Prepare purchases and generaljournals.

(SO 1, 2)

InstructionsFrom the data prepare:(a) the single-column purchases journal for July.(b) the general journal entries for July.

EE-13 Kansas Products uses both special journals and a general journal as described in thischapter. Kansas also posts customers’ accounts in the accounts receivable subsidiary ledger. Thepostings for the most recent month are included in the subsidiary T accounts below.

Problems: Set A E25

InstructionsDetermine the correct amount of the end-of-month posting from the sales journal to theAccounts Receivable control account.

EE-14 Selected account balances for Matisyahu Company at January 1, 2008, are presentedbelow.

Accounts Payable $14,000Accounts Receivable 22,000Cash 17,000Inventory 13,500

Matisyahu’s sales journal for January shows a total of $100,000 in the selling price column,and its one-column purchases journal for January shows a total of $72,000.

The column totals in Matisyahu’s cash receipts journal are: Cash Dr. $61,000; Sales DiscountsDr. $1,100; Accounts Receivable Cr. $45,000; Sales Cr. $6,000; and Other Accounts Cr. $11,100.

The column totals in Matisyahu’s cash payments journal for January are: Cash Cr. $55,000;Inventory Cr. $1,000; Accounts Payable Dr. $46,000; and Other Accounts Dr. $10,000.Matisyahu’s total cost of goods sold for January is $63,600.

Accounts Payable, Accounts Receivable, Cash, Inventory, and Sales are not involved in the“Other Accounts” column in either the cash receipts or cash payments journal, and are not in-volved in any general journal entries.

InstructionsCompute the January 31 balance for Matisyahu in the following accounts.(a) Accounts Payable.(b) Accounts Receivable.(c) Cash.(d) Inventory.(e) Sales.

Bargo LearyBal. 340 250 Bal. 150 150

200 240

Carol PaulBal. –0– 145 Bal. 120 120

145 190150

Determine correct postingamount to control account.

(SO 3)

Compute balances in variousaccounts.

(SO 3)

EXERCISES: SET B

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Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companionsite, to access Exercise Set B.

PROBLEMS: SET APE-1A Grider Company’s chart of accounts includes the following selected accounts.

101 Cash 401 Sales112 Accounts Receivable 414 Sales Discounts120 Merchandise Inventory 505 Cost of Goods Sold311 Common Stock

Journalize transactions in cashreceipts journal; post to controlaccount and subsidiary ledger.

(SO 1, 2, 3)

On April 1 the accounts receivable ledger of Grider Company showed the following balances:Ogden $1,550, Chelsea $1,200, Eggleston Co. $2,900, and Baez $1,800. The April transactions in-volving the receipt of cash were as follows.

Apr. 1 Stockholders invested $7,200 additional cash in the business, in exchange for commonstock.

4 Received check for payment of account from Baez less 2% cash discount.5 Received check for $920 in payment of invoice no. 307 from Eggleston Co.8 Made cash sales of merchandise totaling $7,245. The cost of the merchandise sold was

$4,347.10 Received check for $600 in payment of invoice no. 309 from Ogden.11 Received cash refund from a supplier for damaged merchandise $740.23 Received check for $1,500 in payment of invoice no. 310 from Eggleston Co.29 Received check for payment of account from Chelsea.

Instructions(a) Journalize the transactions above in a six-column cash receipts journal with columns for

Cash Dr., Sales Discounts Dr., Accounts Receivable Cr., Sales Cr., Other Accounts Cr., andCost of Goods Sold Dr./Merchandise Inventory Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Receivable control and subsidiary accounts,and post the April transactions to these accounts.

(c) Prove the agreement of the control account and subsidiary account balances.

PE-2A Ming Company’s chart of accounts includes the following selected accounts.

101 Cash 201 Accounts Payable120 Merchandise Inventory 332 Dividends130 Prepaid Insurance 505 Cost of Goods Sold157 Equipment

On October 1 the accounts payable ledger of Ming Company showed the following balances:Bovary Company $2,700, Nyman Co. $2,500, Pyron Co. $1,800, and Sims Company $3,700. TheOctober transactions involving the payment of cash were as follows.

Oct. 1 Purchased merchandise, check no. 63, $300.3 Purchased equipment, check no. 64, $800.5 Paid Bovary Company balance due of $2,700, less 2% discount, check no. 65, $2,646.

10 Purchased merchandise, check no. 66, $2,250.15 Paid Pyron Co. balance due of $1,800, check no. 67.16 Paid cash dividend of $400, check no. 68.19 Paid Nyman Co. in full for invoice no. 610, $1,600 less 2% cash discount, check no. 69,

$1,568.29 Paid Sims Company in full for invoice no. 264, $2,500, check no. 70.

Instructions(a) Journalize the transactions above in a four-column cash payments journal with columns for

Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr. Footand crossfoot the journal.

(b) Insert the beginning balances in the Accounts Payable control and subsidiary accounts, andpost the October transactions to these accounts.

(c) Prove the agreement of the control account and the subsidiary account balances.

PE-3A The chart of accounts of Lopez Company includes the following selected accounts.

112 Accounts Receivable 401 Sales120 Merchandise Inventory 412 Sales Returns and Allowances126 Supplies 505 Cost of Goods Sold157 Equipment 610 Advertising Expense201 Accounts Payable

In July the following selected transactions were completed. All purchases and sales were on ac-count. The cost of all merchandise sold was 70% of the sales price.

July 1 Purchased merchandise from Fritz Company $8,000.2 Received freight bill from Wayward Shipping on Fritz purchase $400.3 Made sales to Pinick Company $1,300, and to Wayne Bros. $1,500.


(a) Balancing totals $21,205

(c) Accounts Receivable $1,430

Journalize transactions in cashpayments journal; post to con-trol account and subsidiaryledgers.

(SO 1, 2, 3)


(c) Accounts Payable $2,100

Journalize transactions inmulti-column purchasesjournal; post to the general andsubsidiary ledgers.

(SO 1, 2, 3)

5 Purchased merchandise from Moon Company $3,200.8 Received credit on merchandise returned to Moon Company $300.

13 Purchased store supplies from Cress Supply $720.15 Purchased merchandise from Fritz Company $3,600 and from Anton Company $3,300.16 Made sales to Sager Company $3,450 and to Wayne Bros. $1,570.18 Received bill for advertising from Lynda Advertisements $600.21 Made sales to Pinick Company $310 and to Haddad Company $2,800.22 Granted allowance to Pinick Company for merchandise damaged in shipment $40.24 Purchased merchandise from Moon Company $3,000.26 Purchased equipment from Cress Supply $900.28 Received freight bill from Wayward Shipping on Moon purchase of July 24, $380.30 Made sales to Sager Company $5,600.

Instructions(a) Journalize the transactions above in a purchases journal, a sales journal, and a general

journal. The purchases journal should have the following column headings: Date,Account Credited (Debited), Ref., Accounts Payable Cr., Merchandise Inventory Dr., andOther Accounts Dr.

(b) Post to both the general and subsidiary ledger accounts. (Assume that all accounts have zerobeginning balances.)

(c) Prove the agreement of the control and subsidiary accounts.

PE-4A Selected accounts from the chart of accounts of Boyden Company are shown below.

101 Cash 401 Sales112 Accounts Receivable 412 Sales Returns and Allowances120 Merchandise Inventory 414 Sales Discounts126 Supplies 505 Cost of Goods Sold157 Equipment 726 Salaries Expense201 Accounts Payable

The cost of all merchandise sold was 60% of the sales price. During January, Boyden completedthe following transactions.

Jan. 3 Purchased merchandise on account from Wortham Co. $10,000.4 Purchased supplies for cash $80.4 Sold merchandise on account to Milam $5,250, invoice no. 371, terms 1/10, n/30.5 Returned $300 worth of damaged goods purchased on account from Wortham Co. on

January 3.6 Made cash sales for the week totaling $3,150.8 Purchased merchandise on account from Noyes Co. $4,500.9 Sold merchandise on account to Connor Corp. $6,400, invoice no. 372, terms 1/10, n/30.

11 Purchased merchandise on account from Betz Co. $3,700.13 Paid in full Wortham Co. on account less a 2% discount.13 Made cash sales for the week totaling $6,260.15 Received payment from Connor Corp. for invoice no. 372.15 Paid semi-monthly salaries of $14,300 to employees.17 Received payment from Milam for invoice no. 371.17 Sold merchandise on account to Bullock Co. $1,200, invoice no. 373, terms 1/10, n/30.19 Purchased equipment on account from Murphy Corp. $5,500.20 Cash sales for the week totaled $3,200.20 Paid in full Noyes Co. on account less a 2% discount.23 Purchased merchandise on account from Wortham Co. $7,800.24 Purchased merchandise on account from Forgetta Corp. $5,100.27 Made cash sales for the week totaling $4,230.30 Received payment from Bullock Co. for invoice no. 373.31 Paid semi-monthly salaries of $13,200 to employees.31 Sold merchandise on account to Milam $9,330, invoice no. 374, terms 1/10, n/30.

Boyden Company uses the following journals.

1. Sales journal.2. Single-column purchases journal.

Problems: Set A E27

(a) Purchases journal—Accounts Payable $24,100Sales column total $16,530

(c) Accounts Receivable$16,490 Accounts Payable $23,800

Journalize transactions in special journals.

(SO 1, 2, 3)

3. Cash receipts journal with columns for Cash Dr., Sales Discounts Dr., Accounts ReceivableCr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./Merchandise Inventory Cr.

4. Cash payments journal with columns for Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr.

5. General journal.

InstructionsUsing the selected accounts provided:(a) Record the January transactions in the appropriate journal noted.(b) Foot and crossfoot all special journals.(c) Show how postings would be made by placing ledger account numbers and checkmarks as

needed in the journals. (Actual posting to ledger accounts is not required.)

PE-5A Presented below are the purchases and cash payments journals for Reyes Co. for itsfirst month of operations.


(a) Sales journal $22,180Purchases journal $31,100Cash receipts journal

balancing total $29,690Cash payments journal

balancing total $41,780

Journalize in sales and cashreceipts journals; post; preparea trial balance; prove control tosubsidiary; prepare adjustingentries; prepare an adjustedtrial balance.

(SO 1, 2, 3)

PURCHASES JOURNAL P1

Merchandise Inventory Dr.Date Account Credited Ref. Accounts Payable Cr.

July 4 G. Clemens 6,8005 A. Ernst 8,100

11 J. Happy 5,92013 C. Tabor 15,30020 M. Sneezy 7,900

44,020

CASH PAYMENTS JOURNAL CP1

Other Accounts MerchandiseAccount Accounts Payable Inventory Cash

Date Debited Ref. Dr. Dr. Cr. Cr.July 4 Store Supplies 600 600

10 A. Ernst 8,100 81 8,01911 Prepaid Rent 6,000 6,00015 G. Clemens 6,800 6,80019 Dividends 2,500 2,50021 C. Tabor 15,300 153 15,147

9,100 30,200 234 39,066

In addition, the following transactions have not been journalized for July. The cost of all mer-chandise sold was 65% of the sales price.

July 1 D. Reyes invested $80,000 in cash in exchange for common stock.6 Sold merchandise on account to Ewing Co. $6,200 terms 1/10, n/30.7 Made cash sales totaling $6,000.8 Sold merchandise on account to S. Beauty $3,600, terms 1/10, n/30.

10 Sold merchandise on account to W. Pitts $4,900, terms 1/10, n/30.13 Received payment in full from S. Beauty.16 Received payment in full from W. Pitts.20 Received payment in full from Ewing Co.21 Sold merchandise on account to H. Prince $5,000, terms 1/10, n/30.29 Returned damaged goods to G. Clemens and received cash refund of $420.

Instructions(a) Open the following accounts in the general ledger.

101 Cash 127 Store Supplies112 Accounts Receivable 131 Prepaid Rent120 Merchandise Inventory 201 Accounts Payable

311 Common Stock 505 Cost of Goods Sold332 Dividends 631 Supplies Expense401 Sales 729 Rent Expense414 Sales Discounts

(b) Journalize the transactions that have not been journalized in the sales journal, the cash re-ceipts journal (see Illustration E-8), and the general journal.

(c) Post to the accounts receivable and accounts payable subsidiary ledgers. Follow the sequenceof transactions as shown in the problem.

(d) Post the individual entries and totals to the general ledger.(e) Prepare a trial balance at July 31, 2008.(f) Determine whether the subsidiary ledgers agree with the control accounts in the general

ledger.(g) The following adjustments at the end of July are necessary.

(1) A count of supplies indicates that $140 is still on hand.(2) Recognize rent expense for July, $500.Prepare the necessary entries in the general journal. Post the entries to the general ledger.

(h) Prepare an adjusted trial balance at July 31, 2008.

PE-6A The post-closing trial balance for Cortez Co. is as follows.

Problems: Set A E29

(b) Sales journal total $19,700 Cash receipts journal balancing totals $101,120

(e) Totals $119,520(f) Accounts Receivable

$5,000 Accounts Payable $13,820

(h) Totals $119,520

Journalize in special journals;post; prepare a trial balance.

(SO 1, 2, 3)CORTEZ CO.Post-Closing Trial Balance

December 31, 2008

Debit CreditCash $ 41,500Accounts Receivable 15,000Notes Receivable 45,000Merchandise Inventory 23,000Equipment 6,450Accumulated Depreciation—Equipment $ 1,500Accounts Payable 43,000Common Stock 86,450

$130,950 $130,950

The subsidiary ledgers contain the following information: (1) accounts receivable—J. Anders$2,500, F. Cone $7,500, T. Dudley $5,000; (2) accounts payable—J. Feeney $10,000, D. Goodman$18,000, and K. Inwood $15,000. The cost of all merchandise sold was 60% of the sales price.

The transactions for January 2009 are as follows.

Jan. 3 Sell merchandise to M. Rensing $5,000, terms 2/10, n/30.5 Purchase merchandise from E. Vietti $2,000, terms 2/10, n/30.7 Receive a check from T. Dudley $3,500.

11 Pay freight on merchandise purchased $300.12 Pay rent of $1,000 for January.13 Receive payment in full from M. Rensing.14 Post all entries to the subsidiary ledgers. Issued credit of $300 to J. Aders for returned

merchandise.15 Send K. Inwood a check for $14,850 in full payment of account, discount $150.17 Purchase merchandise from G. Marley $1,600, terms 2/10, n/30.18 Pay sales salaries of $2,800 and office salaries $2,000.20 Give D. Goodman a 60-day note for $18,000 in full payment of account payable.23 Total cash sales amount to $9,100.24 Post all entries to the subsidiary ledgers. Sell merchandise on account to F. Cone $7,400,

terms 1/10, n/30.27 Send E. Vietti a check for $950.29 Receive payment on a note of $40,000 from B. Lemke.30 Post all entries to the subsidiary ledgers. Return merchandise of $300 to G. Marley for

credit.

Instructions(a) Open general and subsidiary ledger accounts for the following.

101 Cash 311 Common Stock112 Accounts Receivable 401 Sales115 Notes Receivable 412 Sales Returns and Allowances120 Merchandise Inventory 414 Sales Discounts157 Equipment 505 Cost of Goods Sold158 Accumulated Depreciation—Equipment 726 Sales Salaries Expense200 Notes Payable 727 Office Salaries Expense201 Accounts Payable 729 Rent Expense

(b) Record the January transactions in a sales journal, a single-column purchases journal, a cashreceipts journal (see Illustration E-8), a cash payments journal (see Illustration E-15), and ageneral journal.

(c) Post the appropriate amounts to the general ledger.(d) Prepare a trial balance at January 31, 2009.(e) Determine whether the subsidiary ledgers agree with controlling accounts in the general ledger.


(b) Sales journal $12,400Purchases journal $3,600Cash receipts journal (balancing) $57,600 Cash payments journal(balancing) $22,050

(d) Totals $139,800(e) Accounts Receivable


PROBLEMS: SET BPE-1B Darby Company’s chart of accounts includes the following selected accounts.

101 Cash 401 Sales112 Accounts Receivable 414 Sales Discounts120 Merchandise Inventory 505 Cost of Goods Sold311 Common Stock

On June 1 the accounts receivable ledger of Darby Company showed the following balances:Deering & Son $2,500, Farley Co. $1,900, Grinnell Bros. $1,600, and Lenninger Co. $1,300. TheJune transactions involving the receipt of cash were as follows.

June 1 Stockholders invested $10,000 additional cash in the business, in exchange for commonstock.

3 Received check in full from Lenninger Co. less 2% cash discount.6 Received check in full from Farley Co. less 2% cash discount.7 Made cash sales of merchandise totaling $6,135. The cost of the merchandise sold was

$4,090.9 Received check in full from Deering & Son less 2% cash discount.

11 Received cash refund from a supplier for damaged merchandise $320.15 Made cash sales of merchandise totaling $4,500. The cost of the merchandise sold was

$3,000.20 Received check in full from Grinnell Bros. $1,600.

Instructions(a) Journalize the transactions above in a six-column cash receipts journal with columns for

Cash Dr., Sales Discounts Dr., Accounts Receivable Cr., Sales Cr., Other Accounts Cr., andCost of Goods Sold Dr./Merchandise Inventory Cr. Foot and crossfoot the journal.

(b) Insert the beginning balances in the Accounts Receivable control and subsidiary accounts,and post the June transactions to these accounts.

(c) Prove the agreement of the control account and subsidiary account balances.

PE-2B Gonya Company’s chart of accounts includes the following selected accounts.

101 Cash 157 Equipment120 Merchandise Inventory 201 Accounts Payable130 Prepaid Insurance 332 Dividends

On November 1 the accounts payable ledger of Gonya Company showed the following balances:A. Hess & Co. $4,500, C. Kimberlin $2,350, G. Ruttan $1,000, and Wex Bros. $1,500. TheNovember transactions involving the payment of cash were as follows.

Nov. 1 Purchased merchandise, check no. 11, $1,140.3 Purchased store equipment, check no. 12, $1,700.

Journalize transactions in cashreceipts journal; post to controlaccount and subsidiary ledger.

(SO 1, 2, 3)


(c) Accounts Receivable $0

Journalize transactions in cashpayments journal; post to thegeneral and subsidiary ledgers.

(SO 1, 2, 3)

5 Paid Wex Bros. balance due of $1,500, less 1% discount, check no. 13, $1,485.11 Purchased merchandise, check no. 14, $2,000.15 Paid G. Ruttan balance due of $1,000, less 3% discount, check no. 15, $970.16 Paid cash dividend of $500, check no. 16.19 Paid C. Kimberlin in full for invoice no. 1245, $1,150 less 2% discount, check no. 17,

$1,127.25 Paid premium due on one-year insurance policy, check no. 18, $3,000.30 Paid A. Hess & Co. in full for invoice no. 832, $3,500, check no. 19.

Instructions(a) Journalize the transactions above in a four-column cash payments journal with columns for

Other Accounts Dr., Accounts Payable Dr., Merchandise Inventory Cr., and Cash Cr. Footand crossfoot the journal.

(b) Insert the beginning balances in the Accounts Payable control and subsidiary accounts, andpost the November transactions to these accounts.

(c) Prove the agreement of the control account and the subsidiary account balances.

PE-3B The chart of accounts of Emley Company includes the following selected accounts.

112 Accounts Receivable 401 Sales120 Merchandise Inventory 412 Sales Returns and Allowances126 Supplies 505 Cost of Goods Sold157 Equipment 610 Advertising Expense201 Accounts Payable

In May the following selected transactions were completed. All purchases and sales were on ac-count except as indicated. The cost of all merchandise sold was 65% of the sales price.

May 2 Purchased merchandise from Younger Company $7,500.3 Received freight bill from Ruden Freight on Younger purchase $360.5 Made sales to Ellie Company $1,980, DeShazer Bros. $2,700, and Liu Company $1,500.8 Purchased merchandise from Utley Company $8,000 and Zeider Company $8,700.

10 Received credit on merchandise returned to Zeider Company $500.15 Purchased supplies from Rodriquez Supply $900.16 Purchased merchandise from Younger Company $4,500, and Utley Company $7,200.17 Returned supplies to Rodriquez Supply, receiving credit $100. (Hint: Credit Supplies.)18 Received freight bills on May 16 purchases from Ruden Freight $500.20 Returned merchandise to Younger Company receiving credit $300.23 Made sales to DeShazer Bros. $2,400 and to Liu Company $3,600.25 Received bill for advertising from Amster Advertising $900.26 Granted allowance to Liu Company for merchandise damaged in shipment $200.28 Purchased equipment from Rodriquez Supply $500.

Instructions(a) Journalize the transactions above in a purchases journal, a sales journal, and a general

journal. The purchases journal should have the following column headings: Date,Account Credited (Debited), Ref., Accounts Payable Cr., Merchandise Inventory Dr., andOther Accounts Dr.

(b) Post to both the general and subsidiary ledger accounts. (Assume that all accounts have zerobeginning balances.)

(c) Prove the agreement of the control and subsidiary accounts.

PE-4B Selected accounts from the chart of accounts of Litke Company are shown below.

101 Cash 201 Accounts Payable112 Accounts Receivable 401 Sales120 Merchandise Inventory 414 Sales Discounts126 Supplies 505 Cost of Goods Sold140 Land 610 Advertising Expense145 Buildings

The cost of all merchandise sold was 70% of the sales price. During October, Litke Companycompleted the following transactions.

Problems: Set B E31


(c) Accounts Payable $2,200

Journalize transactions inmulti-column purchasesjournal; post to the general andsubsidiary ledgers.

(SO 1, 2, 3)

(a) Purchases journal—Accounts Payable, Cr.$39,060 Sales column total $12,180

(c) Accounts Receivable$11,980 Accounts Payable $38,160

Journalize transactions in special journals.

(SO 1, 2, 3)

Oct. 2 Purchased merchandise on account from Camacho Company $16,500.4 Sold merchandise on account to Enos Co. $7,700. Invoice no. 204, terms 2/10, n/30.5 Purchased supplies for cash $80.7 Made cash sales for the week totaling $9,160.9 Paid in full the amount owed Camacho Company less a 2% discount.

10 Purchased merchandise on account from Finn Corp. $3,500.12 Received payment from Enos Co. for invoice no. 204.13 Returned $210 worth of damaged goods purchased on account from Finn Corp. on

October 10.14 Made cash sales for the week totaling $8,180.16 Sold a parcel of land for $27,000 cash, the land’s original cost.17 Sold merchandise on account to G. Richter & Co. $5,350, invoice no. 205, terms 2/10, n/30.18 Purchased merchandise for cash $2,125.21 Made cash sales for the week totaling $8,200.23 Paid in full the amount owed Finn Corp. for the goods kept (no discount).25 Purchased supplies on account from Robinson Co. $260.25 Sold merchandise on account to Hunt Corp. $5,220, invoice no. 206, terms 2/10, n/30.25 Received payment from G. Richter & Co. for invoice no. 205.26 Purchased for cash a small parcel of land and a building on the land to use as a storage fa-

cility.The total cost of $35,000 was allocated $21,000 to the land and $14,000 to the building.27 Purchased merchandise on account from Kudro Co. $8,500.28 Made cash sales for the week totaling $7,540.30 Purchased merchandise on account from Camacho Company $14,000.30 Paid advertising bill for the month from the Gazette, $400.30 Sold merchandise on account to G. Richter & Co. $4,600, invoice no. 207, terms 2/10, n/30.

Litke Company uses the following journals.

1. Sales journal.2. Single-column purchases journal.3. Cash receipts journal with columns for Cash Dr., Sales Discounts Dr., Accounts

Receivable Cr., Sales Cr., Other Accounts Cr., and Cost of Goods Sold Dr./MerchandiseInventory Cr.

4. Cash payments journal with columns for Other Accounts Dr., Accounts Payable Dr.,Merchandise Inventory Cr., and Cash Cr.

5. General journal.

InstructionsUsing the selected accounts provided:(a) Record the October transactions in the appropriate journals.(b) Foot and crossfoot all special journals.(c) Show how postings would be made by placing ledger account numbers and check marks as

needed in the journals. (Actual posting to ledger accounts is not required.)

PE-5B Presented below are the sales and cash receipts journals for Wyrick Co. for its firstmonth of operations.


SALES JOURNAL S1Accounts Receivable Dr. Cost of Goods Sold Dr.

Date Account Debited Ref. Sales Cr. Merchandise Inventory Cr.Feb. 3 S. Arndt 5,500 3,630

9 C. Boyd 6,500 4,29012 F. Catt 8,000 5,28026 M. Didde 7,000 4,620

27,000 17,820

(b) Sales journal $22,870Purchases journal $42,500 Cash receipts journal—

Cash, Dr. $72,869 Cash payments journal,

Cash, Cr. $57,065

Journalize in purchases andcash payments journals; post;prepare a trial balance; provecontrol to subsidiary; prepareadjusting entries; prepare anadjusted trial balance.

(SO 1, 2, 3)

In addition, the following transactions have not been journalized for February 2008.

Feb. 2 Purchased merchandise on account from J. Vopat for $4,600, terms 2/10, n/30.7 Purchased merchandise on account from P. Kneiser for $30,000, terms 1/10, n/30.9 Paid cash of $1,250 for purchase of supplies.

12 Paid $4,508 to J. Vopat in payment for $4,600 invoice, less 2% discount.15 Purchased equipment for $7,000 cash.16 Purchased merchandise on account from J. Nunez $2,400, terms 2/10, n/30.17 Paid $29,700 to P. Kneiser in payment of $30,000 invoice, less 1% discount.20 Paid cash dividend of $1,100.21 Purchased merchandise on account from G. Reedy for $7,800, terms 1/10, n/30.28 Paid $2,400 to J. Nunez in payment of $2,400 invoice.

Instructions(a) Open the following accounts in the general ledger.

101 Cash 311 Common Stock112 Accounts Receivable 332 Dividends120 Merchandise Inventory 401 Sales126 Supplies 414 Sales Discounts157 Equipment 505 Cost of Goods Sold158 Accumulated Depreciation—Equipment 631 Supplies Expense201 Accounts Payable 711 Depreciation Expense

(b) Journalize the transactions that have not been journalized in a one-column purchases jour-nal and the cash payments journal (see Illustration E-15).

(c) Post to the accounts receivable and accounts payable subsidiary ledgers. Follow the sequenceof transactions as shown in the problem.

(d) Post the individual entries and totals to the general ledger.(e) Prepare a trial balance at February 29, 2008.(f) Determine that the subsidiary ledgers agree with the control accounts in the general ledger.(g) The following adjustments at the end of February are necessary.

(1) A count of supplies indicates that $300 is still on hand.(2) Depreciation on equipment for February is $200.Prepare the adjusting entries and then post the adjusting entries to the general ledger.

(h) Prepare an adjusted trial balance at February 29, 2008.

Comprehensive Problem: Chapters 3 to 6 and Appendix E E33

CASH RECEIPTS JOURNAL CR1Sales Accounts Other

Cash Discounts Receivable Sales Accounts Cost of Goods Sold Dr.Date Account Credited Ref. Dr. Dr. Cr. Cr. Cr. Merchandise Inventory Cr.

Feb. 1 Common Stock 30,000 30,0002 6,500 6,500 4,290

13 S. Arndt 5,445 55 5,50018 Merchandise Inventory 150 15026 C. Boyd 6,500 6,500

48,595 55 12,000 6,500 30,150 4,290

PROBLEMS: SET C

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COMPREHENSIVE PROBLEM: CHAPTERS 3 TO 6 AND APPENDIX E

Packard Company has the following opening account balances in its general and subsidiary ledgers onJanuary 1 and uses the periodic inventory system.All accounts have normal debit and credit balances.

(b) Purchases journal total$44,800 Cash payments journal—Cash, Cr. $45,958

(e) Totals $71,300(f) Accounts Receivable


(h) Totals $71,500

Visit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companionsite, to access Problem Set C.

Jan. 3 Sell merchandise on account to B. Remy $3,100, invoice no. 510, and J. Fine $1,800,invoice no. 511.

5 Purchase merchandise on account from S. Yost $3,000 and D. Laux $2,700.7 Receive checks for $4,000 from S. Ingles and $2,000 from B. Hachinski.8 Pay freight on merchandise purchased $180.9 Send checks to S. Kosko for $9,000 and D. Moreno for $11,000.9 Issue credit of $300 to J. Fine for merchandise returned.

10 Summary cash sales total $15,500.11 Sell merchandise on account to R. Draves for $1,900, invoice no. 512, and to S. Ingles

$900, invoice no. 513.Post all entries to the subsidiary ledgers.

12 Pay rent of $1,000 for January.13 Receive payment in full from B. Remy and J. Fine.15 Pay cash dividend of $800.16 Purchase merchandise on account from D. Moreno for $15,000, from S. Kosko for

$13,900, and from S. Yost for $1,500.17 Pay $400 cash for office supplies.18 Return $200 of merchandise to S. Kosko and receive credit.20 Summary cash sales total $17,500.21 Issue $15,000 note to R. Mikush in payment of balance due.21 Receive payment in full from S. Ingles.

Post all entries to the subsidiary ledgers.22 Sell merchandise on account to B. Remy for $3,700, invoice no. 514, and to R. Draves for

$800, invoice no. 515.23 Send checks to D. Moreno and S. Kosko in full payment.25 Sell merchandise on account to B. Hachinski for $3,500, invoice no. 516, and to J. Fine

for $6,100, invoice no. 517.27 Purchase merchandise on account from D. Moreno for $12,500, from D. Laux for $1,200,

and from S. Yost for $2,800.28 Pay $200 cash for office supplies.31 Summary cash sales total $22,920.31 Pay sales salaries of $4,300 and office salaries of $3,600.


General LedgerAccount January 1Number Account Title Opening Balance

101 Cash $33,750112 Accounts Receivable 13,000115 Notes Receivable 39,000120 Merchandise Inventory 20,000125 Office Supplies 1,000130 Prepaid Insurance 2,000157 Equipment 6,450158 Accumulated Depreciation 1,500201 Accounts Payable 35,000311 Common Stock 70,000320 Retained Earnings 8,700

Accounts Payable Subsidiary LedgerJanuary 1Opening

Creditor BalanceS. Kosko $ 9,000R. Mikush 15,000D. Moreno 11,000

Accounts Receivable Subsidiary LedgerJanuary 1Opening

Customer BalanceR. Draves $1,500B. Hachinski 7,500S. Ingles 4,000

Instructions(a) Record the January transactions in the appropriate journal—sales, purchases, cash receipts,

cash payments, and general.(b) Post the journals to the general and subsidiary ledgers. Add and number new accounts in an

orderly fashion as needed.(c) Prepare a trial balance at January 31, 2008, using a worksheet. Complete the worksheet using

the following additional information.(1) Office supplies at January 31 total $700.(2) Insurance coverage expires on October 31, 2008.(3) Annual depreciation on the equipment is $1,500.(4) Interest of $30 has accrued on the note payable.(5) Merchandise inventory at January 31 is $15,000.

(d) Prepare a multiple-step income statement and a retained earnings statement for January anda classified balance sheet at the end of January.

(e) Prepare and post the adjusting and closing entries.(f) Prepare a post-closing trial balance, and determine whether the subsidiary ledgers agree with

the control accounts in the general ledger.

Broadening Your Perspective E35

(c) Trial balance totals$196,820; Adj. T/B totals $196,975

(d) Net income $9,685 Total assets $126,315

(f) Post-closing T/B totals$127,940


Financial Reporting Problem—Mini Practice SetBYPE-1 (You will need the working papers that accompany this textbook in order to workthis mini practice set.)Bluma Co. uses a perpetual inventory system and both an accounts receivable and an accountspayable subsidiary ledger. Balances related to both the general ledger and the subsidiary ledgerfor Bluma are indicated in the working papers. Presented below are a series of transactions forBluma Co. for the month of January. Credit sales terms are 2/10, n/30. The cost of all merchan-dise sold was 60% of the sales price.

Jan. 3 Sell merchandise on account to B. Richey $3,100, invoice no. 510, and to J. Forbes $1,800,invoice no. 511.

5 Purchase merchandise from S. Vogel $5,000 and D. Lynch $2,200, terms n/30.7 Receive checks from S.LaDew $4,000 and B.Garcia $2,000 after discount period has lapsed.8 Pay freight on merchandise purchased $235.9 Send checks to S. Hoyt for $9,000 less 2% cash discount, and to D. Omara for $11,000

less 1% cash discount.9 Issue credit of $300 to J. Forbes for merchandise returned.

10 Summary daily cash sales total $15,500.11 Sell merchandise on account to R. Dvorak $1,600, invoice no. 512, and to S. LaDew

$900, invoice no. 513.12 Pay rent of $1,000 for January.13 Receive payment in full from B. Richey and J. Forbes less cash discounts.14 Pay an $800 cash dividend.15 Post all entries to the subsidiary ledgers.16 Purchase merchandise from D. Omara $18,000, terms 1/10, n/30; S. Hoyt $14,200, terms

2/10, n/30; and S. Vogel $1,500, terms n/30.17 Pay $400 cash for office supplies.18 Return $200 of merchandise to S. Hoyt and receive credit.20 Summary daily cash sales total $20,100.21 Issue $15,000 note, maturing in 90 days, to R. Moses in payment of balance due.21 Receive payment in full from S. LaDew less cash discount.22 Sell merchandise on account to B. Richey $2,700, invoice no. 514, and to R. Dvorak

$1,300, invoice no. 515.22 Post all entries to the subsidiary ledgers.

23 Send checks to D. Omara and S. Hoyt in full payment less cash discounts.25 Sell merchandise on account to B. Garcia $3,500, invoice no. 516, and to J. Forbes $6,100,

invoice no. 517.27 Purchase merchandise from D. Omara $14,500, terms 1/10, n/30; D. Lynch $1,200, terms

n/30; and S. Vogel $5,400, terms n/30.27 Post all entries to the subsidiary ledgers.28 Pay $200 cash for office supplies.31 Summary daily cash sales total $21,300.31 Pay sales salaries $4,300 and office salaries $3,800.

Instructions(a) Record the January transactions in a sales journal, a single-column purchases journal, a cash

receipts journal as shown on page E8, a cash payments journal as shown on page E14, and atwo-column general journal.

(b) Post the journals to the general ledger.(c) Prepare a trial balance at January 31, 2008, in the trial balance columns of the worksheet.

Complete the worksheet using the following additional information.(1) Office supplies at January 31 total $900.(2) Insurance coverage expires on October 31, 2008.(3) Annual depreciation on the equipment is $1,500.(4) Interest of $50 has accrued on the note payable.

(d) Prepare a multiple-step income statement and a retained earnings statement for January anda classified balance sheet at the end of January.

(e) Prepare and post adjusting and closing entries.(f) Prepare a post-closing trial balance, and determine whether the subsidiary ledgers agree with

the control accounts in the general ledger.

Exploring the WebBYPE-2 Great Plains’ Accounting is one of the leading accounting software packages. Infor-mation related to this package is found at its website.

Address: www.microsoft.com/dynamics/gp/product/demos.mspx, or go to www.wiley.com/college/weygandt

Steps1. Go to the site shown above.2. Choose General Ledger. Perform instruction (a).3. Choose Accounts Payable. Perform instruction (b).

Instructions(a) What are three key features of the general ledger module highlighted by the company?(b) What are three key features of the payables management module highlighted by the company?


CRITICAL THINKINGDecision Making Across the OrganizationBYPE-3 Hughey & Payne is a wholesaler of small appliances and parts. Hughey & Payne isoperated by two owners, Rich Hughey and Kristen Payne. In addition, the company has oneemployee, a repair specialist, who is on a fixed salary. Revenues are earned through the sale ofappliances to retailers (approximately 75% of total revenues), appliance parts to do-it-yourselfers(10%), and the repair of appliances brought to the store (15%). Appliance sales are made onboth a credit and cash basis. Customers are billed on prenumbered sales invoices. Credit termsare always net/30 days. All parts sales and repair work are cash only.

Merchandise is purchased on account from the manufacturers of both the appliances andthe parts. Practically all suppliers offer cash discounts for prompt payments, and it is companypolicy to take all discounts. Most cash payments are made by check. Checks are most fre-quently issued to suppliers, to trucking companies for freight on merchandise purchases, andto newspapers, radio, and TV stations for advertising. All advertising bills are paid as received.

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Rich and Kristen each make a monthly drawing in cash for personal living expenses. Thesalaried repairman is paid twice monthly. Hughey & Payne currently has a manual account-ing system.


(a) Identify the special journals that Hughey & Payne should have in its manual system. List thecolumn headings appropriate for each of the special journals.

(b) What control and subsidiary accounts should be included in Hughey & Payne manualsystem? Why?

Communication ActivityBYPE-4 Barb Doane, a classmate, has a part-time bookkeeping job. She is concerned aboutthe inefficiencies in journalizing and posting transactions. Jim Houser is the owner of the com-pany where Barb works. In response to numerous complaints from Barb and others, Jim hiredtwo additional bookkeepers a month ago. However, the inefficiencies have continued at an evenhigher rate. The accounting information system for the company has only a general journal anda general ledger. Jim refuses to install an electronic accounting system.

InstructionsNow that Barb is an expert in manual accounting information systems, she decides to send aletter to Jim Houser explaining (1) why the additional personnel did not help and (2) whatchanges should be made to improve the efficiency of the accounting department. Write the let-ter that you think Barb should send.

Ethics CaseBYPE-5 Roniger Products Company operates three divisions, each with its own manufactur-ing plant and marketing/sales force. The corporate headquarters and central accounting officeare in Roniger, and the plants are in Freeport, Rockport, and Bayport, all within 50 miles ofRoniger. Corporate management treats each division as an independent profit center and en-courages competition among them.They each have similar but different product lines.As a com-petitive incentive, bonuses are awarded each year to the employees of the fastest growing andmost profitable division.

Jose Molina is the manager of Roniger’s centralized computer accounting operation thatenters the sales transactions and maintains the accounts receivable for all three divisions. Josecame up in the accounting ranks from the Bayport division where his wife, several relatives, andmany friends still work.

As sales documents are entered into the computer, the originating division is identifiedby code. Most sales documents (95%) are coded, but some (5%) are not coded or are codedincorrectly. As the manager, Jose has instructed the data-entry personnel to assign the Bayportcode to all uncoded and incorrectly coded sales documents. This is done he says, “in order toexpedite processing and to keep the computer files current since they are updated daily.” Allreceivables and cash collections for all three divisions are handled by Roniger as one subsidiaryaccounts receivable ledger.

Instructions(a) Who are the stakeholders in this situation?(b) What are the ethical issues in this case?(c) How might the system be improved to prevent this situation?

Answers to Self-Study Questions1. a 2. c 3. a 4. c 5. d 6. b 7. c 8. c

Broadening Your Perspective E37

F1

Other Significant Liabilities

Appendix F

In addition to the current and long-term liabilities discussed in Chapter 11, severalmore types of liabilities may exist that could have a significant impact on a com-pany’s financial position and future cash flows. These other significant liabilitieswill be discussed in this appendix. They are: (a) contingent liabilities, (b) lease lia-bilities, and (c) additional liabilities for employee fringe benefits (paid absencesand postretirement benefits).

After studying this appendix, you should be able to:1. Describe the accounting and disclosure requirements for

contingent liabilities.2. Contrast the accounting for operating and capital leases.3. Identify additional fringe benefits associated with employee

compensation.

S T U D Y O B J E C T I V E

CONTINGENT LIABILITIESWith notes payable, interest payable, accounts payable, and sales taxespayable, we know that an obligation to make a payment exists. But sup-pose that your company is involved in a dispute with the Internal RevenueService (IRS) over the amount of its income tax liability. Should you re-port the disputed amount as a liability on the balance sheet? Or supposeyour company is involved in a lawsuit which, if you lose, might result in bankruptcy.How should you report this major contingency? The answers to these questions aredifficult, because these liabilities are dependent—contingent—upon some futureevent. In other words, a contingent liability is a potential liability that may becomean actual liability in the future.

How should companies report contingent liabilities? They use the followingguidelines:

1. If the contingency is probable (if it is likely to occur) and the amount can bereasonably estimated, the liability should be recorded in the accounts.

2. If the contingency is only reasonably possible (if it could happen), then it needsto be disclosed only in the notes that accompany the financial statements.

3. If the contingency is remote (if it is unlikely to occur), it need not be recordedor disclosed.

Recording a Contingent LiabilityProduct warranties are an example of a contingent liability that companies shouldrecord in the accounts. Warranty contracts result in future costs that companiesmay incur in replacing defective units or repairing malfunctioning units. Generally,

Describe the accounting anddisclosure requirements forcontingent liabilities.


a manufacturer, such as Black & Decker, knows that it will incur some warrantycosts. From prior experience with the product, the company usually can reasonablyestimate the anticipated cost of servicing (honoring) the warranty.

The accounting for warranty costs is based on the matching principle. The esti-mated cost of honoring product warranty contracts should be recognized as an ex-pense in the period in which the sale occurs. To illustrate, assume that in 2008Denson Manufacturing Company sells 10,000 washers and dryers at an averageprice of $600 each.The selling price includes a one-year warranty on parts. Densonexpects that 500 units (5%) will be defective and that warranty repair costs will av-erage $80 per unit. In 2008, the company honors warranty contracts on 300 units, ata total cost of $24,000.

At December 31, it is necessary to accrue the estimated warranty costs on the2008 sales. Denson computes the estimated warranty liability as follows.

F2 Appendix F Other Significant Liabilities

Number of units sold 10,000Estimated rate of defective units � 5%

Total estimated defective units 500Average warranty repair cost � $80

Estimated product warranty liability $40,000

Illustration F-1 Computation of estimatedproduct warranty liability

The company makes the following adjusting entry.

Dec. 31 Warranty Expense 40,000Estimated Warranty Liability 40,000

(To accrue estimated warranty costs)

Denson records those repair costs incurred in 2008 to honor warranty contractson 2008 sales as shown below.

Jan. 1� Estimated Warranty Liability 24,000Dec. 31 Repair Parts 24,000

(To record honoring of 300 warranty contracts on 2008 sales)

The company reports warranty expense of $40,000 under selling expenses in theincome statement. It classifies estimated warranty liability of $16,000 ($40,000 �$24,000) as a current liability on the balance sheet.

In the following year, Denson should debit to Estimated Warranty Liabilityall expenses incurred in honoring warranty contracts on 2008 sales. To illustrate,assume that the company replaces 20 defective units in January 2009, at an aver-age cost of $80 in parts and labor. The summary entry for the month of January2009 is:

Jan. 31 Estimated Warranty Liability 1,600Repair Parts 1,600

(To record honoring of 20 warranty contracts on 2008 sales)

Disclosure of Contingent LiabilitiesWhen it is probable that a company will incur a contingent liability but it cannotreasonably estimate the amount, or when the contingent liability is only reasonablypossible, only disclosure of the contingency is required. Examples of contingencies

Cash Flowsno effect

A � L � SE�40,000 Exp

�40,000

Cash Flowsno effect

A � L � SE�24,000

�24,000

Cash Flowsno effect

A � L � SE�1,600

�1,600

that may require disclosure are pending or threatened lawsuits and assessment ofadditional income taxes pending an IRS audit of the tax return.

The disclosure should identify the nature of the item and, if known, the amountof the contingency and the expected outcome of the future event. Disclosure is usu-ally accomplished through a note to the financial statements, as illustrated by thefollowing.

Lease Liabilities F3

The required disclosure for contingencies is a good example of the use of thefull-disclosure principle. The full-disclosure principle requires that companies dis-close all circumstances and events that would make a difference to financial state-ment users. Some important financial information, such as contingencies, is not eas-ily reported in the financial statements. Reporting information on contingencies inthe notes to the financial statements will help investors be aware of events that canaffect the financial health of a company.

YAHOO! INC.Notes to the Financial Statements

Contingencies. From time to time, third parties assert patent infringement claims againstthe company. Currently the company is engaged in several lawsuits regarding patent issuesand has been notified of a number of other potential patent disputes. In addition, from timeto time the company is subject to other legal proceedings and claims in the ordinary courseof business, including claims for infringement of trademarks, copyrights and other intellectualproperty rights.... The Company does not believe, based on current knowledge, that any ofthe foregoing legal proceedings or claims are likely to have a material adverse effect on thefinancial position, results of operations or cash flows.

Illustration F-2 Disclosure of contingent liability

LEASE LIABILITIESA lease is a contractual arrangement between a lessor (owner of a property)and a lessee (renter of the property). It grants the right to use specificproperty for a period of time in return for cash payments. Leasing is bigbusiness. U.S. companies leased an estimated $125 billion of capital equip-ment in a recent year. This represents approximately one-third of equipmentfinanced that year. The two most common types of leases are operating leases andcapital leases.

Operating LeasesThe renting of an apartment and the rental of a car at an airport are examples ofoperating leases. In an operating lease the intent is temporary use of the propertyby the lessee, while the lessor continues to own the property.

In an operating lease, the lessee records the lease (or rental) payments as anexpense. The lessor records the payments as revenue. For example, assume that asales representative for Western Inc. leases a car from Hertz Car Rental at the LosAngeles airport and that Hertz charges a total of $275. Western, the lessee, recordsthe rental as follows:

Car Rental Expense 275Cash 275

(To record payment of lease rental charge)

Contrast the accounting foroperating and capital leases.


A � L � SE�275 Exp

�275

Cash Flows�275

The lessee may incur other costs during the lease period. For example, in the caseabove, Western will generally incur costs for gas. Western would report these costsas an expense.

Capital LeasesIn most lease contracts, the lessee makes a periodic payment and records thatpayment in the income statement as rent expense. In some cases, however, thelease contract transfers to the lessee substantially all the benefits and risks ofownership. Such a lease is in effect a purchase of the property. This type of leaseis a capital lease. Its name comes from the fact that the company capitalizes thepresent value of the cash payments for the lease and records that amount as anasset. Illustration F-3 indicates the major difference between operating andcapital leases.


If any one of the following conditions exists, the lessee must record a lease asan asset—that is, as a capital lease:

1. The lease transfers ownership of the property to the lessee. Rationale: If duringthe lease term the lessee receives ownership of the asset, the lessee should re-port the leased asset as an asset on its books.

2. The lease contains a bargain purchase option. Rationale: If during the term ofthe lease the lessee can purchase the asset at a price substantially below its fairmarket value, the lessee will exercise this option.Thus, the lessee should reportthe lease as a leased asset on its books.

3. The lease term is equal to 75% or more of the economic life of the leased prop-erty. Rationale: If the lease term is for much of the asset’s useful life, the lesseeshould report the asset as a leased asset on its books.

4. The present value of the lease payments equals or exceeds 90% of the fair mar-ket value of the leased property. Rationale: If the present value of the leasepayments is equal to or almost equal to the fair market value of the asset, thelessee has essentially purchased the asset. As a result, the lessee should reportthe leased asset as an asset on its books.

H E L P F U L H I N TA capital lease situationis one that, althoughlegally a rental case, is insubstance an installmentpurchase by the lessee.Accounting standards re-quire that substance overform be used in such asituation.

Illustration F-3Types of leases

Operatinglease

Lessee has substantially all of thebenefits and risks of ownership

Capitallease

“Have it backby 6:00 Sunday.”

“OK!”

Lessor has substantially all of thebenefits and risks of ownership

“Only 3 morepayments and this baby

is ours!”

To illustrate, assume that Gonzalez Company decides to lease new equipment.The lease period is four years; the economic life of the leased equipment is esti-mated to be five years. The present value of the lease payments is $190,000, whichis equal to the fair market value of the equipment. There is no transfer of owner-ship during the lease term, nor is there any bargain purchase option.

In this example, Gonzalez has essentially purchased the equipment. Conditions3 and 4 have been met. First, the lease term is 75% or more of the economic life ofthe asset. Second, the present value of cash payments is equal to the equipment’sfair market value. Gonzalez records the transaction as follows.

Leased Asset—Equipment 190,000Lease Liability 190,000

(To record leased asset and lease liability)

The lessee reports a leased asset on the balance sheet under plant assets. It re-ports the lease liability on the balance sheet as a liability. The portion of the leaseliability expected to be paid in the next year is a current liability. The remainder isclassified as a long-term liability.

Most lessees do not like to report leases on their balance sheets. Why?Because the lease liability increases the company’s total liabilities. This, inturn, may make it more difficult for the company to obtain needed fundsfrom lenders. As a result, companies attempt to keep leased assets andlease liabilities off the balance sheet by structuring leases so as not to meetany of the four conditions mentioned on page F4. The practice of keepingliabilities off the balance sheet is referred to as off-balance-sheet financing.

Additional Liabilities for Employee Fringe Benefits F5

E T H I C S N O T E

Accounting standard settersare attempting to rewrite

rules on lease accounting becauseof concerns that abuse of the cur-rent standards is reducing theusefulness of financial statements.

A � L � SE�190,000

�190,000

Cash Flowsno effect

ADDITIONAL LIABILITIES FOR EMPLOYEE FRINGE BENEFITS

In addition to the three payroll tax fringe benefits discussed in AppendixD (FICA taxes and state and federal unemployment taxes), employers in-cur other substantial fringe benefit costs. Indeed, fringe benefits have beengrowing faster than pay. In a recent year, benefits equaled 38 percent ofwages and salaries.While vacations and other forms of paid leave still takethe biggest bite out of the benefits pie, as shown in Illustration F-4, medical costsare the fastest-growing item.

Illustration F-4The fringe benefits pieBENEFITS

3% Disability and life insurance

23% Legally required benefitssuch as Social Security

24% Medical benefits

37% Vacation and other benefitssuch as parental and sick leaves, child care

13% Retirement incomesuch as pensions

We discuss two of the most important fringe benefits—paid absences andpostretirement benefits—in this section.

Identify additional fringe benefitsassociated with employeecompensation.


Paid AbsencesEmployees often are given rights to receive compensation for absences when cer-tain conditions of employment are met. The compensation may be for paid vaca-tions, sick pay benefits, and paid holidays. When the payment for such absences isprobable and the amount can be reasonably estimated, a liability should be ac-crued for paid future absences. When the amount cannot be reasonably estimated,companies should instead disclose the potential liability. Ordinarily, vacation pay isthe only paid absence that is accrued. The other types of paid absences are onlydisclosed.1

To illustrate, assume that Academy Company employees are entitled to oneday’s vacation for each month worked. If 30 employees earn an average of $110 perday in a given month, the accrual for vacation benefits in one month is $3,300. Theliability is recognized at the end of the month by the following adjusting entry.

Jan. 31 Vacation Benefits Expense 3,300Vacation Benefits Payable 3,300

(To accrue vacation benefits expense)

This accrual is required by the matching principle.Academy would report VacationBenefits Expense as an operating expense in the income statement, and VacationBenefits Payable as a current liability in the balance sheet.

Later, when Academy pays vacation benefits, it debits Vacation BenefitsPayable and credits Cash. For example, if the above benefits for 10 employees arepaid in July, the entry is:

July 31 Vacation Benefits Payable 1,100Cash 1,100

(To record payment of vacation benefits)

The magnitude of unpaid absences has gained employers’ attention. Considerthe case of an assistant superintendent of schools who worked for 20 years andrarely took a vacation or sick day. A month or so before she retired, the school dis-trict discovered that she was due nearly $30,000 in accrued benefits. Yet the schooldistrict had never accrued the liability.

Postretirement BenefitsPostretirement benefits are benefits provided by employers to retired employeesfor (1) health care and life insurance and (2) pensions. For many years theaccounting for postretirement benefits was on a cash basis. Companies now ac-count for both types of postretirement benefits on the accrual basis. The cost ofpostretirement benefits is getting steep. For example, General Motor’s pension andhealth-care costs for retirees in a recent year totaled $6.2 billion, or approximately$1,784 per vehicle produced.

The average American has debt of approximately $10,000 (not counting themortgage on their home) and has little in the way of savings. What will happen atretirement for these people? The picture is not pretty—people are living longer,the future of Social Security is unclear, and companies are cutting back on post-retirement benefits. This situation may lead to one of the great social and moraldilemmas this country faces in the next 40 years. The more you know about post-


A � L � SE�3,300 Exp

�3,300

A � L � SE�1,100

�1,100

Cash Flows�1,100

Cash Flowsno effect

1The typical U.S. company provides an average of 12 days of paid vacation for its employees, at anaverage cost of 5% of gross earnings.

retirement benefits, the better you will understand the issues involved in thisdilemma.

POSTRETIREMENT HEALTH-CARE AND LIFE INSURANCE BENEFITSProviding medical and related health-care benefits for retirees was at one time aninexpensive and highly effective way of generating employee goodwill. This prac-tice has now turned into one of corporate America’s most worrisome financialproblems. Runaway medical costs, early retirement, and increased longevity aresending the liability for retiree health plans through the roof.

Many companies began offering retiree health-care coverage in the form ofMedicare supplements in the 1960s. Almost all plans operated on a pay-as-you-gobasis. The companies simply paid for the bills as they came in, rather than settingaside funds to meet the cost of future benefits. These plans were accounted for onthe cash basis. But, the FASB concluded that shareholders and creditors shouldknow the amount of the employer’s obligations. As a result, employers must nowuse the accrual basis in accounting for postretirement health-care and life insur-ance benefits.

PENSION PLANSA pension plan is an agreement whereby an employer provides benefits (pay-ments) to employees after they retire. Over 50 million workers currently partici-pate in pension plans in the United States. The need for good accounting for pen-sion plans becomes apparent when one appreciates the size of existing pensionfunds. Most pension plans are subject to the provisions of ERISA (EmployeeRetirement Income Security Act), a law enacted to curb abuses in the administra-tion and funding of such plans.

Three parties are generally involved in a pension plan. The employer (com-pany) sponsors the pension plan.The plan administrator receives the contributionsfrom the employer, invests the pension assets, and makes the benefit payments tothe pension recipients (retired employees). Illustration F-5 indicates the flow ofcash among the three parties involved in a pension plan.

Additional Liabilities for Employee Fringe Benefits F7

Illustration F-5Parties in a pension plan

Contributions Benefits

Fund Assets:Investments and Earnings

Employer Plan Administrator Pension Recipients

Kear Trust Co.

An employer-financed pension is part of the employees’ compensation.ERISA establishes the minimum contribution that a company must make eachyear toward employee pensions. The most popular type of pension plan used is the401(k) plan. A 401(k) plan works as follows: As an employee, you can contribute upto a certain percentage of your pay into a 401(k) plan, and your employer will matcha percentage of your contribution.These contributions are then generally invested instocks and bonds through mutual funds. These funds will grow without being taxedand can be withdrawn beginning at age 59-1/2. If you must access the funds earlier,you may be able to do so, but a penalty usually occurs along with a payment of tax

on the proceeds. Any time you have the opportunity to be involved in a 401(k)plan, you should avail yourself of this benefit!

Companies record pension costs as an expense while the employees are work-ing because that is when the company receives benefits from the employees’ serv-ices. Generally the pension expense is reported as an operating expense in thecompany’s income statement. Frequently, the amount contributed by the companyto the pension plan is different from the amount of the pension expense. A liabilityis recognized when the pension expense to date is more than the company’s con-tributions to date. An asset is recognized when the pension expense to date is lessthan the company’s contributions to date. Further consideration of the accountingfor pension plans is left for more advanced courses.

The two most common types of pension arrangements for providing benefitsto employees after they retire are defined-contribution plans and defined-benefitplans.

Defined-Contribution Plan. In a defined-contribution plan, the plan defines theemployer’s contribution but not the benefit that the employee will receive at re-tirement. That is, the employer agrees to contribute a certain sum each periodbased on a formula. A 401(k) plan is typically a defined-contribution plan.

The accounting for a defined-contribution plan is straightforward: The em-ployer simply makes a contribution each year based on the formula established inthe plan. As a result, the employer’s obligation is easily determined. It follows thatthe company reports the amount of the contribution required each period as pen-sion expense. The employer reports a liability only if it has not made the contribu-tion in full.

To illustrate, assume that Alba Office Interiors Corp. has a defined-contributionplan in which it contributes $200,000 each year to the pension fund for its employees.The entry to record this transaction is:

Pension Expense 200,000Cash 200,000

(To record pension expense and contribution topension fund)

To the extent that Alba did not contribute the $200,000 defined contribution, itwould record a liability. Pension payments to retired employees are made from thepension fund by the plan administrator.

Defined-Benefit Plan. In a defined-benefit plan, the benefits that the employeewill receive at the time of retirement are defined by the terms of the plan. Benefitsare typically calculated using a formula that considers an employee’s compensationlevel when he or she nears retirement and the employee’s years of service. Becausethe benefits in this plan are defined in terms of uncertain future variables, an ap-propriate funding pattern is established to ensure that enough funds are availableat retirement to meet the benefits promised. This funding level depends on a num-ber of factors such as employee turnover, length of service, mortality, compensationlevels, and investment earnings. The proper accounting for these plans is complexand is considered in more advanced accounting courses.

POSTRETIREMENT BENEFITS AS LONG-TERM LIABILITIESWhile part of the liability associated with (1) postretirement health-care and life in-surance benefits and (2) pension plans is generally a current liability, the greaterportion of these liabilities extends many years into the future. Therefore, manycompanies are required to report significant amounts as long-term liabilities forpostretirement benefits.


A � L � SE�200,000

�200,000

Cash Flows�200,000

1 Describe the accounting and disclosure requirementsfor contingent liabilities. If it is probable that the contin-gency will happen (if it is likely to occur) and the amountcan be reasonably estimated, the liability should berecorded in the accounts. If the contingency is only reason-ably possible (it could occur), then it should be disclosedonly in the notes to the financial statements. If the possibil-ity that the contingency will happen is remote (unlikely tooccur), it need not be recorded or disclosed.

2 Contrast the accounting for operating and capitalleases. For an operating lease, lease (or rental) payments

Self-Study Questions F9

REVIEW IT1. What is a contingent liability?2. How are contingent liabilities reported in financial statements?3. What accounts are involved in accruing and paying vacation benefits?4. What basis should be used in accounting for postretirement benefits?

Before You Go On...

SUMMARY OF STUDY OBJECTIVESare recorded as an expense by the lessee (renter). For acapital lease, the lessee records the asset and related obli-gation at the present value of the future lease payments.

3 Identify additional fringe benefits associated with em-ployee compensation. Additional fringe benefits associ-ated with wages are paid absences (paid vacations, sick paybenefits, and paid holidays), postretirement health care andlife insurance, and pensions. The two most common typesof pension arrangements are a defined-contribution planand a defined-benefit plan.

GLOSSARYCapital lease A contractual arrangement that transfers

substantially all the benefits and risks of ownership to thelessee so that the lease is in effect a purchase of the prop-erty. (p. F4).

Contingent liability A potential liability that may becomean actual liability in the future. (p. F1).

Defined-benefit plan A pension plan in which the bene-fits that the employee will receive at retirement are definedby the terms of the plan. (p. F8).

Defined-contribution plan A pension plan in which theemployer’s contribution to the plan is defined by the termsof the plan. (p. F8).

Lease A contractual arrangement between a lessor (ownerof a property) and a lessee (renter of the property). (p. F3).

Operating lease A contractual arrangement giving the les-see temporary use of the property, with continued owner-ship of the property by the lessor. (p. F3).

Pension plan An agreement whereby an employerprovides benefits to employees after they retire. (p. F7).

Postretirement benefits Payments by employers to retiredemployees for health care, life insurance, and pensions.(p. F6).

SELF-STUDY QUESTIONSAnswers are at the end of the appendix.

1. A contingency should be recorded in the accounts when:a. It is probable the contingency will happen but the

amount cannot be reasonably estimated.b. It is reasonably possible the contingency will happen

and the amount can be reasonably estimated.c. It is reasonably possible the contingency will happen

but the amount cannot be reasonably estimated.d. It is probable the contingency will happen and the

amount can be reasonably estimated.

2. At December 31, Anthony Company prepares an adjust-ing entry for a product warranty contract. Which of thefollowing accounts are included in the entry?a. Warranty Expense.b. Estimated Warranty Liability.c. Repair Parts/Wages Payable.d. Both (a) and (b).

3. Lease A does not contain a bargain purchase option, butthe lease term is equal to 90 percent of the estimatedeconomic life of the leased property. Lease B does not

(SO 1)

(SO 1)

(SO 2)

transfer ownership of the property to the lessee by the endof the lease term, but the lease term is equal to 75 percentof the estimated economic life of the lease property. Howshould the lessee classify these leases?

Lease A Lease B

a. Operating lease Capital leaseb. Operating lease Operating leasec. Capital lease Capital leased. Capital lease Operating lease

4. Which of the following is not an additional fringe benefit?a. Salaries.b. Paid absences.c. Paid vacations.d. Postretirement pensions.


(SO 3)

QUESTIONS1. What is a contingent liability? Give an example of a con-

tingent liability that is usually recorded in the accounts.2. Under what circumstances is a contingent liability dis-

closed only in the notes to the financial statements?Under what circumstances is a contingent liability notrecorded in the accounts nor disclosed in the notes tothe financial statements?

3. (a) What is a lease agreement? (b) What are the twomost common types of leases? (c) Distinguish betweenthe two types of leases.

4. Orbison Company rents a warehouse on a month-to-month basis for the storage of its excess inventory. Thecompany periodically must rent space when its productiongreatly exceeds actual sales.What is the nature of this typeof lease agreement, and what accounting treatment shouldbe accorded it?

5. Costello Company entered into an agreement to lease12 computers from Estes Electronics Inc. The presentvalue of the lease payments is $186,300. Assuming thatthis is a capital lease, what entry would Costello Companymake on the date of the lease agreement?

6. Identify three additional types of fringe benefits associ-ated with employees’ compensation.

7. Often during job interviews, the candidate asks the poten-tial employer about the firm’s paid absences policy. Whatare paid absences? How are they accounted for?

8. What are the two types of postretirement benefits?During what years does the FASB advocate expensing theemployer’s costs of these postretirement benefits?

9. What basis of accounting for the employer’s cost ofpostretirement health-care and life insurance benefitshas been used by most companies, and what basis does theFASB advocate in the future? Explain the basic differencebetween these methods in recognizing postretirementbenefit costs.

10. Identify the three parties in a pension plan. What roledoes each party have in the plan?

11. Brenna Ottare and Caitlin Wilkes are reviewing pensionplans. They ask your help in distinguishing between adefined-contribution plan and a defined-benefit plan.Explain the principal difference to Brenna and Caitlin.


BRIEF EXERCISESBEF-1 On December 1, Vina Company introduces a new product that includes a 1-year war-ranty on parts. In December 1,000 units are sold. Management believes that 5% of the units willbe defective and that the average warranty costs will be $60 per unit. Prepare the adjusting entryat December 31 to accrue the estimated warranty cost.

BEF-2 Prepare the journal entries that the lessee should make to record the followingtransactions.

1. The lessee makes a lease payment of $80,000 to the lessor in an operating lease transaction.2. Zander Company leases a new building from Joel Construction, Inc.The present value of the

lease payments is $900,000. The lease qualifies as a capital lease.

BEF-3 In Alomar Company, employees are entitled to 1 day’s vacation for each monthworked. In January, 50 employees worked the full month. Record the vacation pay liability forJanuary assuming the average daily pay for each employee is $120.

Record estimated vacationbenefits.

(SO 3)

Prepare entries for operatingand capital leases.

(SO 2)

Prepare adjusting entry forwarranty costs.

(SO 1)

Exercises: Set B F11

EXERCISESEF-1 Boone Company sells automatic can openers under a 75-day warranty for defective mer-chandise. Based on past experience, Boone Company estimates that 3% of the units sold willbecome defective during the warranty period. Management estimates that the average cost ofreplacing or repairing a defective unit is $15. The units sold and units defective that occurredduring the last 2 months of 2006 are as follows.

Units Units DefectiveMonth Sold Prior to December 31

November 30,000 600December 32,000 400

Instructions(a) Determine the estimated warranty liability at December 31 for the units sold in November

and December.(b) Prepare the journal entries to record the estimated liability for warranties and the costs (assume

actual costs of $15,000) incurred in honoring 1,000 warranty claims.(c) Give the entry to record the honoring of 500 warranty contracts in January at an average cost

of $15.

EF-2 Larkin Online Company has the following liability accounts after posting adjustingentries: Accounts Payable $63,000, Unearned Ticket Revenue $24,000, Estimated WarrantyLiability $18,000, Interest Payable $8,000, Mortgage Payable $120,000, Notes Payable $80,000,and Sales Taxes Payable $10,000. Assume the company’s operating cycle is less than 1 year, ticketrevenue will be earned within 1 year, warranty costs are expected to be incurred within 1 year,and the notes mature in 3 years.

Instructions(a) Prepare the current liabilities section of the balance sheet, assuming $40,000 of the mortgage

is payable next year.(b) Comment on Larkin Online Company’s liquidity, assuming total current assets are

$300,000.

EF-3 Presented below are two independent situations.

1. Speedy Car Rental leased a car to Rundgren Company for 1 year. Terms of the operating leaseagreement call for monthly payments of $500.

2. On January 1, 2008, Miles Inc. entered into an agreement to lease 20 computers from HaloElectronics. The terms of the lease agreement require three annual rental payments of$40,000 (including 10% interest) beginning December 31, 2008. The present value of thethree rental payments is $99,474. Miles considers this a capital lease.

Instructions(a) Prepare the appropriate journal entry to be made by Rundgren Company for the first lease

payment.(b) Prepare the journal entry to record the lease agreement on the books of Miles Inc. on

January 1, 2008.

EF-4 Bunill Company has two fringe benefit plans for its employees:1. It grants employees 2 days’ vacation for each month worked. Ten employees worked the

entire month of March at an average daily wage of $80 per employee.2. It has a defined contribution pension plan in which the company contributes 10% of

gross earnings. Gross earnings in March were $30,000. The payment to the pension fund hasnot been made.

InstructionsPrepare the adjusting entries at March 31.

Record estimated liability andexpense for warranties.

(SO 1)

Prepare the current liabilitiessection of the balance sheet.

(SO 1)

Prepare journal entries for op-erating lease and capital lease.

(SO 2)

Prepare adjusting entries forfringe benefits.

(SO 3)

EXERCISES: SET BVisit the book’s website at www.wiley.com/college/weygandt, and choose the Student Companionsite, to access Exercise Set B.

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PF-1A On January 1, 2008, the ledger of Shumway Software Company contains the followingliability accounts.

Accounts Payable $42,500Sales Taxes Payable 5,800Unearned Service Revenue 15,000

During January the following selected transactions occurred.

Jan. 1 Borrowed $15,000 in cash from Amsterdam Bank on a 4-month, 8%, $15,000 note.5 Sold merchandise for cash totaling $10,400 which includes 4% sales taxes.

12 Provided services for customers who had made advance payments of $9,000. (CreditService Revenue.)

14 Paid state treasurer’s department for sales taxes collected in December 2007 ($5,800).20 Sold 700 units of a new product on credit at $52 per unit, plus 4% sales tax. This new

product is subject to a 1-year warranty.25 Sold merchandise for cash totaling $12,480, which includes 4% sales taxes.

Instructions(a) Journalize the January transactions.(b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and (2)

estimated warranty liability, assuming warranty costs are expected to equal 5% of sales ofthe new product.

(c) Prepare the current liabilities section of the balance sheet at January 31, 2008. Assume nochange in accounts payable.

PF-2A Presented below are three different lease transactions in which Ortiz Enterprisesengaged in 2008.Assume that all lease transactions start on January 1, 2008. In no case does Ortizreceive title to the properties leased during or at the end of the lease term.

Lessor

Schoen Inc. Casey Co. Lester Inc.Type of property Bulldozer Truck FurnitureBargain purchase option None None NoneLease term 4 years 6 years 3 yearsEstimated economic life 8 years 7 years 5 yearsYearly rental $13,000 $15,000 $4,000Fair market value of leased

asset $80,000 $72,000 $27,500Present value of the lease

rental payments $48,000 $62,000 $12,000

Instructions(a) Identify the leases above as operating or capital leases. Explain.(b) How should the lease transaction with Casey Co. be recorded on January 1, 2008?(c) How should the lease transactions for Lester Inc. be recorded in 2008?


PROBLEMS: SET APrepare current liability entries,adjusting entries, and currentliabilities section.

(SO 1)

Analyze three different leasesituations and prepare journalentries.

(SO 2)

PROBLEMS: SET BPF-1B On January 1, 2008, the ledger of Zaur Company contains the following liabilityaccounts.

Accounts Payable $52,000Sales Taxes Payable 7,700Unearned Service Revenue 16,000

During January the following selected transactions occurred.

Jan. 5 Sold merchandise for cash totaling $17,280, which includes 8% sales taxes.12 Provided services for customers who had made advance payments of $10,000.

(Credit Service Revenue.)

Prepare current liability entries,adjusting entries, and currentliabilities section.

(SO 1)

14 Paid state revenue department for sales taxes collected in December 2007 ($7,700).20 Sold 600 units of a new product on credit at $50 per unit, plus 8% sales tax. This new

product is subject to a 1-year warranty.21 Borrowed $18,000 from UCLA Bank on a 3-month, 9%, $18,000 note.25 Sold merchandise for cash totaling $12,420, which includes 8% sales taxes.

Instructions(a) Journalize the January transactions.(b) Journalize the adjusting entries at January 31 for (1) the outstanding notes payable, and (2)

estimated warranty liability, assuming warranty costs are expected to equal 7% of sales ofthe new product. (Hint: Use one-third of a month for the UCLA Bank note.)

(c) Prepare the current liabilities section of the balance sheet at January 31, 2008. Assume nochange in accounts payable.

PF-2B Presented below are three different lease transactions that occurred for Milo Inc. in2008. Assume that all lease contracts start on January 1, 2008. In no case does Milo receive titleto the properties leased during or at the end of the lease term.

Lessor

Gibson Delivery Eller Co. Louis Auto

Type of property Computer Delivery equipment AutomobileYearly rental $ 8,000 $ 4,200 $ 3,700Lease term 6 years 4 years 2 yearsEstimated economic life 7 years 7 years 5 yearsFair market value of leased asset $44,000 $19,000 $11,000Present value of the lease rental

payments $41,000 $13,000 $6,400Bargain purchase option None None None

Instructions(a) Which of the leases above are operating leases and which are capital leases? Explain.(b) How should the lease transaction with Eller Co. be recorded in 2008?(c) How should the lease transaction for Gibson Delivery be recorded on January 1, 2008?

Broadening Your Perspective F13

Analyze three different leasesituations and prepare journalentries.

(SO 2)

PROBLEMS: SET CVisit the book’s website at www.wiley.com/college/weygandt, and choose the StudentCompanion site, to access Problem Set C.

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Financial Reporting ProblemsBYPF-1 Refer to the financial statements of PepsiCo and the Notes to Consolidated FinancialStatements in Appendix A to answer the following questions about contingent liabilities, leaseliabilities, and pension costs.

(a) Where does PepsiCo report its contingent liabilities?(b) What is management’s opinion as to the ultimate effect of the “various claims and legal pro-

ceedings” pending against the company?(c) Where did PepsiCo report the details of its lease obligations? What amount of rent expense

from operating leases did PepsiCo incur in 2005? What was PepsiCo’s total future minimumannual rental commitment under noncancelable operating leases as of December 31, 2005?

(d) What type of employee pension plan does PepsiCo have?(e) What is the amount of postretirement benefit expense (other than pensions) for 2005?

BYPF-2 Presented below is the lease portion of the notes to the financial statements of CF In-dustries, Inc.

CF INDUSTRIES, INC.Notes to the Financial Statements

Leases The present value of future minimum capital lease payments and the future minimumlease payments under noncancelable operating leases at December 31, 2006, are:

(in millions) Capital Lease Operating Lease

Payments Payments

2007 $ 7,733 $3,0672008 6,791 2,0522009 6,730 1,0562010 6,788 9182011 6,785 86Thereafter 13,441 6

Future minimum lease payments 48,268 $7,185Less: Equivalent interest 11,391

Present value 36,877Less: Current portion 5,570

$31,307

Rent expense for operating leases was $7.0 million for the year ended December 31, 2006, $5.3million for 2005, and $5.6 million for 2004.

InstructionsWhat type of leases does CF Industries, Inc. use? What is the amount of the current portion ofthe capital lease obligation?


CRITICAL THINKINGDecision Making Across the OrganizationBYPF-3 Presented below is the condensed balance sheet for Express, Inc. as of December 31,2008.

EXPRESS, INC.Balance Sheet

December 31, 2008

Current assets $ 800,000 Current liabilities $1,200,000Plant assets 1,600,000 Long-term liabilities 700,000

Common stock 400,000Retained earnings 100,000

Total $2,400,000 Total $2,400,000

Express has decided that it needs to purchase a new crane for its operations. The new cranecosts $900,000 and has a useful life of 15 years. However, Express’s bank has refused to provideany help in financing the purchase of the new equipment, even though Express is willing to payan above-market interest rate for the financing.

The chief financial officer for Express, Lisa Colder, has discussed with the manufacturer ofthe crane the possibility of a lease agreement. After some negotiation, the crane manufactureragrees to lease the crane to Express under the following terms: length of the lease 7 years; pay-ments $100,000 per year. The present value of the lease payments is $548,732.

The board of directors at Express is delighted with this new lease. They reason they havethe use of the crane for the next 7 years. In addition, Lisa Colder notes that this type of fi-nancing is a good deal because it will keep debt off the balance sheet.


(a) Why do you think the bank decided not to lend money to Express, Inc.?(b) How should this lease transaction be reported in the financial statements?(c) What did Lisa Colder mean when she said “leasing will keep debt off the balance sheet”?

Answers to Self-Study Questions1. d 2. d 3. c 4. a

Broadening Your Perspective F15

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PC-1

P H O T O C R E D I T S

AABC, 445Ace Hardware, 271Adelphia, 10Advanced Micro, 540AIG, 8Alcatel-Alsthom, 298Alliance Atlantis Communications Inc., 676Altria Group, 470, 603, 634Aluminum Company of America

(Alcoa), 581Amazon.com, 560, 696America Bank, 412American Airlines, 102, 479American Cancer Society, 534American Eagle Outfitters, 350American Express, 396, 473American Standard, 707America Online (AOL), 470, 595, 597Anaheim Angels, 604AOL Time Warner, 597Apple Computer, 6, 115, 298, 443, 715Arthur Andersen, 537AT&T, 4, 603Avis, 425, 431, 604

BBabies “R” Us, 604BankAmerica, 314Bank of America, 11Bank One Corporation, 70Batten Ltd., 325–326Baylor University, 514Berkshire Hathaway, 470Best Buy, 9, 104, 140Bill and Melinda Gates Foundation, 29, 534Black & Decker Manufacturing

Company, 255Boeing Capital Corporation, 429Boeing Company, 440, 470, 485, 552, 710Boise Cascade, 434Book-of-the-Month Club, 595Breyer, 470Bristol-Myers Squibb, 215, 255, 722Budget, 425

CCadbury-Schweppes, 10Campbell Soup Company, 255, 433, 707Capital Cities/ABC, Inc., 604Cargill Inc., 535Caterpillar Inc., 244–246, 257, 480, 481, 535Caterpillar Logistics Services, Inc., 245Cendant Corp., 314, 604Century 21, 604Chase, 70Chevron, 434Cisco Systems, 155, 193, 289, 404, 470, 722Citibank, 409Citigroup, 11CNN, 595Coca-Cola Amatil Limited, B2The Coca-Cola Company, 3, 5, 10, 11, 42, 43,

87, 100, 137, 163, 191, 215, 240, 243, 289, 333,381, 421, 468, 470, 480, 528, 589, 618, 632, 692,744, B1–B4

Coca-Cola Enterprises Inc., B2Coca-Cola FEMSA, S.A. de C.V., B2Coca-Cola Hellenic Bottling Company

S.A., B2Coldwell Banker, 604

Columbia Sportswear Company, 676Computer Associates International, 106ConAgra Foods, 212Consolidated Edison, 711Continental Bank, 429Costco Wholesale Corp., 641, D1Craig Consumer Electronics, 249Crane Company, 551Cypress Semiconductor Corporation, 676

DDaimlerChrysler Corporation, 296, 491Dairy Queen, 470DeKalb Genetics Corporation, 626Dell Computer, 60, 247, 298, 605Dell Financial Services, 429Delta Air Lines, 23, 45, 95, 102, 440Discover, 395Disney Company, see The Walt Disney

CompanyDisneyland, 604DisneyWorld, 604Dun & Bradstreet, 309, 699Dunkin’ Donuts, 23, 45DuPont, 484, 485Dynegy, Inc., 644, 694

EEarthLink, 552Eastman Kodak Company, 346, 363, 606, 638eBay, 357Enron, 8, 29, 213, 301, 314, 340, 537, 591,

722, 746ESPN, 445, 470, 604Estée Lauder Companies, Inc., 724–725ExxonMobil, 11, 296, 298, 470, 547

FFannie Mae, 70, 108Fidelity Investments, 47, 48First National Bank, 12Florida Citrus Company, 718Ford Motor Company, 4, 11, 198, 258, 296,

532–536, 547Frito-Lay, 315, A9, A10, A12, A13

GGE, see General ElectricGeneral Dynamics, 745General Electric (GE), 7, 10, 204, 213, 298, 301,

341, 470, 535, 597General Mills, 433General Motors (GM), 6–7, 11, 194, 296, 302,

410, 538, 650, 695, 721, 728Global Crossing, 301, 340GM, see General MotorsGoldman Sachs, 11Google, 29, 534, 540Gulf Oil, 538

HHarley-Davidson, 215Harold’s Club, 301, 335HBO, 595HealthSouth, 8Hershey Foods Corp., 552Hertz, 425, F3Hewlett-Packard, 298Hilton, 429Home Depot, 4, 247, 271, 428Howard Johnson, 604

IIBM, 71, 213, 242, 298, 535, 539n.2Imaginarium, 604Intel Corporation, 325, 535, 555, 560InterContinental, 429International Harvester, 3IT&T, 2

JJ. Crew, 350J.C. Penney Company, Inc., 349, 387, 412–413,

641, 698–700, 704–715John Deere Capital Corporation, 429Johnson & Johnson, 310, 325J.P. Morgan Leasing, 429

KKellogg Company, 12, 29, 495, 560, 565, 566Kids “R” Us, 604Kmart, 196, 310, 699, 710, 717Kodak, see Eastman Kodak CompanyKohl’s Corporation, 641KPMG LLP, A27, A29Kraft Foods, Inc., 597, 603, 634Krispy Kreme Doughnuts, 215Kroger Stores, 198, 255, 310, 710, 711K2, Inc., 164

LLeslie Fay Cos., 248, 290The Limited, 296Limited Brands, 100Little, Brown & Co., 595L.L. Bean, 296Lockheed Martin Corporation, 155, 440, 561Long Beach City College, 334Lotus, 71Lucent Technologies, 314

MMcDonald’s Corporation, 11, 443, 455, 470,

493, 534McKesson Corporation, 196, 290Major League Baseball Players Association, 7Marriott, 429, 433Marshall Farms, 626Massachusetts General Hospital, 11MasterCard, 395–397, 412, 416Merck, 310Merrill Lynch, 11Microsoft Corporation, 6, 11, 56, 89, 204, 295,

302, 443, 470, 547, 555, 636–637, 655, 728Mighty Ducks, 604Minnesota Mining and Manufacturing Company,

see 3MMitsubishi Motors, 402, 423Moody’s, 529, 699Morgan Stanley, 608Morrow Snowboards, Inc., 199Motorola, 255, 325, 720

NNationsBank, 314NBC, 470New York Stock Exchange, 609Nike, Inc., 4, 100, 542, 552, 553, 558, 705–706Nordstrom, Inc., 166, 397, 423, 732–733Nortel Networks, 394, 715North American Van Lines, 542Northern Virginia Community College, 11Northwest Airlines, 94, 166

C O M PA N Y I N D E X

I-1

OOffice Depot, 196Oracle Corporation, 655Owens-Illinois, 446, 447

PPACE Membership Warehouse, 717PayLess Drug Stores Northwest, 717PayPal, 357PepsiAmericas, A20Pepsi Bottling Group, A19–A20, A22, A23PepsiCo, Inc., 3–6, 10, 13, 42–43, 45, 53, 86–87,

90, 95, 100, 104, 137, 140, 168, 190–191, 193,213, 214, 239–240, 243, 257, 258, 288–289, 291,298, 315, 333, 336, 365, 380–381, 383, 394, 421,423, 430, 468, 471, 480, 481, 492, 528, 531, 534,541, 546, 550, 551, 559, 565, 588–589, 592,604, 632, 635, 642, 692, 695, 743–744, 747,A1–A30, F13

PepsiCo Beverages North America, A9, A10,A12, A13

PepsiCo International, A9, A10, A12, A13Pfizer, 310P&G, see Procter & Gamble CompanyPhilip Morris, 470, 597, 603Pizza Hut, 470Planet Hollywood, 514PNC Financial Services Group Inc., 567Policy Management Systems, 292Procter & Gamble Company (P&G), 11, 446,

447, 470, 542, 720Prudential Real Estate, 11

QQuaker, A24Quaker Foods, 257, A9, A10, A12, A13, A30Qualcomm, 538Qwest, 310

RRadio Shack, 71, 90Ramada Inn, 604Red Cross, 29Reebok International Ltd., 255, 541, 548

Regions Financial Corp., 567Rent-A-Wreck, 425–428, 431, 433, 443, 445,

448, 470Rent-Way Inc., 293Republic Carloading, 160Reynolds Company, 653–654Rhino Foods, Inc., 142–144Robert Half and Co., 30Royal Dutch/Shell Group, 442, 445

SSafeway, 310, 710Salvation Army, 534SAM’S CLUB, 261Samsung Electronics Co., 262, 291Sears, Roebuck, and Company, 195, 349, 387Sears Holdings, 296Shell, see Royal Dutch/Shell GroupSnack Ventures Europe, A5Southern Company, 325Sports Illustrated, 479Springfield ReManufacturing Corporation, 2–4Standard & Poor’s, 699Starbucks, 29, 255, 695Stephanie’s Gourmet Coffee and More,

338–341, 344, 345Sunbeam Corporation, 243, 292–293Sunset Books, 595SunTrust Banks Inc., 346

TTaco Bell, 445, 470Target Corporation, 196, 247, 355, 641, 739Tektronix Inc., 561Texaco Oil Company, 4093M Company, 411, 518Tiffany & Co., 710Time-Life Books, 595Time Warner, Inc., 7, 164, 298, 470, 547,

594–597, 601, 603TNT, 595Toys “R” Us, Inc., 325, 346, 604Trek, 11True Value Hardware, 247

Turner Broadcasting, 597, 601, 603Twentieth Century Fox, 96Tyco, 340

UU.S. Olympic Committee, 71United Airlines, 7, 102, 479, 638United Stationers, 196USAir, 491US Bancorp Equipment Finance, 429USX Corp., 491

VVeritas Software, 71Verizon Communications, 310Visa, 395–397, 406, 409, 411, 413, 419

WWalgreen Drugs, 196, 255Wall Street Journal, 8, 537, 541Wal-Mart Stores, Inc., 11, 58, 90, 194–196, 199,

200, 204, 247, 248, 261–262, 271, 291, 310, 349,355, 555, 641, 710, 739, A11

The Walt Disney Company, 7, 23, 45, 95, 295,470, 560, 603, 604

Warner Bros., 595Waste Management Company, 70Wells Fargo Bank, 340Wendy’s International, 255, 470Weyerhaeuser Co., 718Whirlpool, 707Whitehall-Robins, 384–385, 393WorldCom, Inc., 8, 29, 93, 301, 314, 340, 438,

470, 644, 694, 722

XXerox, 93

YYahoo! Inc., 163, 696, F3Yale Express, 160, 193YUM! Brands, 470, A22

I-2 Company Index

AAbsences, paid, F6Accelerated-depreciation method, 435Account(s), 48–53

chart of, 60–61control, E1–E2T, 48three-column form of, 58

Accounting:basic activities of, 4–5career opportunities in, 29–30

Accounting cycle:optional steps in, 162–164required steps in, 161–162

Accounting cycle tutorialadjusting entries, 97preparing financial statements and closing

the books, 148recording process, 61

Accounting data, users of, 6–7Accounting principle, changes in, 720Accounts payable subsidiary ledger, E1Accounts receivable, 386–398

defined, 386disposing of, 395–398recognizing, 387types of, 386valuing, 388–395

Accounts receivable subsidiary ledger, E1Accounts receivable turnover ratio,

403–404. See also Receivables turnoverAccruals, adjusting entries for, 97, 105–110

expenses, accrued, 106–109revenues, accrued, 105–106

Accrual-basis accounting, cash-basis vs., 95Accrued expenses, 106–109Accrued interest, 107–108Accrued revenues, 105–106Acid-test (quick) ratio, 707–708Additional paid-in capital, 564Additions and improvements, 438Adjustable-rate mortgages, 493Adjusted trial balance:

preparation of, 112preparing financial statements from,

113–114, 116Adjusting entries, 97–111

for accruals, 105–110expenses, accrued, 106–109revenues, accrued, 105–106

classes of, 97–98for deferrals, 98–105

prepaid expenses, 98–102unearned revenues, 102–103

example of journalizing/posting, 110–111for merchandising operations, 207preparing, from worksheets, 148, 150, 152, 154purpose of, 97

Administrative expenses, 211Affiliated (subsidiary) company, 602Agents:

collection, 476of corporations, 535

Aging schedule, 393Aging the accounts receivable, 393Allowance for Doubtful Accounts, 390, 393Allowance method, 389–394Alternative accounting methods, 721–722Amortization, 443

of bonds, 506–513straight-line method, 509–513

Annual report(s), 71, A1Annuity(-ies):

defined, C5, C10future value of an, C5–C7present value of an, 502–503, C10–C12, C16

Assets, 12depreciable, 431in double-entry system, 49return on, 311, 711

Asset turnover ratio, 446–447, 710–711Assumptions, accounting, 9–11, 298–299Auditing, as area of public accounting, 29Auditors, internal, 345–346Authorized stock, 540Auto loans, calculating, C17Available-for-sale securities, 605, 607–608Averages, industry, 699Average collection period, 404Average-cost method, 254–255, 267–268

BBad Debts Expense, 388, 391Balance sheet, 21–23. See also Classified

balance sheetconsolidated, 615–618effects of cost flow methods on, 257effects of inventory errors on, 260–261horizontal analysis of, 700–701investments on, 608–609stockholders’ equity section of, 564–565vertical analysis of, 703

Bank(s), 355–362deposits to, 355and writing checks, 355–357

Bank accounts, reconciling, 359–362Banking, investment, 540Bank reconciliation, 355, 359–362

entries from, 361–362example of, 360–361procedure for, 359–360

Bank service charges, 357Bank statements, 357–358Basic accounting equation, 11–13

expansion of, 52–53using, 14–20

Bearer (coupon) bonds, 484Best-efforts contracts, 540n.3Blank, Arthur, 4Bond(s), 482–492, 500–513

amortization of, 506–513effective-interest method, 506–509straight-line method, 509–513

bearer, 484callable, 484conversion of, to common stock, 491–492defined, 482determining market value of, 486discounting of, 487–488, 503–504issuance of:

accounting for, 487–490at discount, 488–489at face value, 487at premium, 489–490procedures for, 484

premiums on, 487–488present value of, 504–505and present value of annuity, 502–503present value of face value of, 500–502pricing of, 500–505recording acquisition of, 598recording interest from, 598

recording sale of, 598–599redemption of:

at maturity, 491before maturity, 491

registered, 484retirement of, 489–492secured, 483trading of, 484–485

Bond discount, 488–489amortization of, 506–508, 510–511defined, 488

Bonding, 346Bond premium, 489–490

amortization of, 508–509, 511–513defined, 488

Bonuses, D4Bookkeeping, 5Book value, 102, 431Book value per share, 571–572Buildings, 428Business documents, 54, 203By-laws, 538

CCalculator, using a, C16–C17Calendar year, 95Callable bonds, 484Canceled checks, 357Capital, 305

ability of corporations to acquire, 535corporate, 542paid-in, 542working, 309–310, 481, 707

Capital expenditures, 438Capital leases, F4–F5Capital stock, 564Careers, accounting, 29–30Carrying (book) value:

of convertible bonds, 491–492defined, 489

Carrying (book) value method, 492Cash:

defined, 348net change in:

direct method, 671indirect method, 652–654

reporting, 363, 365–366restricted, 363

Cash-basis accounting, accrual-basis vs., 95Cash controls, 347–355

disbursements, 351–355receipts, 348–351

Cash disbursements journal, see Cashpayments journal

Cash dividends, 51, 552–555Cash equivalents, 363Cash flow(s):

classification of, 639–640free, 654–655statement of, see Statement of cash flows

Cash payments journal, E13–E15Cash (net) realizable value, 389, 400Cash receipts journal, E7–E11Cash register tapes, 203Cash sales, credit card sales as, 396–397Castle, Ted, 142–143CEO (chief executive officer), 536Certified public accountants (CPAs), 29Changes in accounting principle, 720Channel stuffing, 215, 722Charter, 538

S U B J E C T I N D E X

I-3

Chart of accounts, 60–61Check(s):

canceled, 357outstanding, 359paying payroll via, D4writing, 355–357

Check register, 352Chief executive officer (CEO), 536Classified balance sheet, 161–166, 168–170,

305–306current assets on, 162–163current liabilities on, 165–166examples of, 168–170intangible assets on, 164long-term investments on, 163long-term liabilities on, 166for merchandising operations, 213, 214property, plant, and equipment on, 164stockholders’ equity on, 166valuing/reporting of investments on, 610–611

Classified financial statements, 305–308Classified income statement, 306–308Closing entries:

for merchandising operations, 207posting of, 153–154, 157–158preparation of, 151–153, 155–157

Closing the books, 154–161defined, 154and posting of closing entries, 157–158and preparation of closing entries, 155–157and preparation of post-closing trial balance,

159–161Collection agents, 476Collection period, average, 404Collusion, 347Common stock, 50, 538–546

cash dividend allocation, 554, 555issuance of, 540–546and owners’ equity, 542–543and ownership rights of stockholders, 538–539par-value vs. no-par-value, 544–546for services or noncash assets, 545–546

Common stockholders’ equity, return on, 311,566, 711–712

Comparability of accounting information, 296Comparative analysis, 698–699Compensating balances, 363Compound entries, 55–56Compound interest, C2–C3Comprehensive income, 610, 720Computer controls, 344Conceptual framework, 295Conservatism, 258, 304Consigned goods, 249Consistency, of accounting information, 296Consistency principle, 257–258Consolidated balance sheet, 615–618Consolidated income statement, 618Constraints, accounting, 303–304Consumerism, 194, 195Consumption, 194–195Contingent liabilities, F1–F3Continuous life (of corporation), 536Contra asset accounts, 101, 488Contracts, best-efforts, 540n.3Contractual interest rate, 484, 488Contra-revenue accounts, 204Contra stockholders’ equity account, 547–548Controls, internal, see Internal control(s)Control accounts, E1–E2Controller, 536Controlling interest, 603Convertible bonds, 484, 491–492Copyrights, 444Corporate capital, 542Corporation(s), 532–543

book value per share of, 571–572

characteristics of, 535–537classification of, 534–535defined, 10, 534formation of, 538issuance of stock by, 540–542owners’ equity in, 542–543ownership of, 538–539

Correcting entries, 158–160Cost(s):

depreciable, 432expired/unexpired, 300organization, 538of plant assets, 427–430research and development, 446

Cost flow assumptions, 251–255, 266–269Cost method:

and stock investments, 600for valuation of treasury stock, 547

Cost of goods sold:defined, 196determining, under periodic system, 216–218and matching principle, 300

Cost principle, 302, 598Coupon (bearer) bonds, 484CPAs (certified public accountants), 29Credit, 49Credit cards:

sales via, 396–397using, 405

Credit memoranda, 358Creditors, long- vs. short-term, 698Creditors’ subsidiary ledger, E1Credit sales, journalizing, E5Credit terms, 201–202Cumulative dividend, 551–552Current assets:

on classified balance sheet, 162–163and current liabilities, 474

Current liabilities, 474–482changes in, 649on classified balance sheet, 165–166and current assets, 474defined, 474long-term debt, current maturities of, 479–480notes payable, 475–476payroll and payroll taxes payable, 476–478sales taxes payable, 476statement presentation/analysis of, 480–482unearned revenues, 479

Current maturities of long-term debt, 479–480Current ratio, 309, 706–707Current replacement cost, 258Customers’ subsidiary ledger, E1

DDays in inventory, 262Debenture bonds, 484Debit, 49Debit memoranda, 357Debt investments, 597–598Debt to total assets ratio, 311–312, 495, 714–715Declaration date, 553Declining-balance method, 434–435Deferrals, adjusting entries for, 97–105

prepaid expenses, 98–102unearned revenues, 102–103

Deficits, 560Defined-benefit plans, F8Defined-contribution plans, F8Depletion, 442Deposits, bank, 355Deposits in transit, 359Depreciable assets, 431Depreciable cost, 432Depreciation:

declining-balance method of, 434–435defined, 101, 430

of plant assets, 430–438computation, 431–432and income taxes, 436methods, 432–436revisions in estimate of, 436–437

as prepaid expense, 101straight-line method of, 432–433units-of-activity method of, 433–434

Depreciation expense, 646–647Direct method (of preparing statement of cash

flows), 644, 665–671investing/financing activities, 670–671net change in cash, 671operating activities, cash provided/used by,

666–670Direct write-off method, 388–389Disbursements, cash, 351–355

and EFT system, 352–353and petty cash fund, 353–355and voucher system, 351–352

Discontinued operations, 717–718Discount(s):

bonds issued at, 488–489, 506–508, 510–511purchase, 201–202sales, 205

Discounting the future amount, C7, C12Discount period, 202Dishonored notes, 401–402Disposal:

of accounts receivable, 395–398of notes receivable, 401–402of plant assets, 439–441

retirement, 439–440sale, 440–441

of treasury stock, 548–550Dividend(s), 51, 558

cash, 552–555cumulative, 551–552defined, 13, 552preferred, 712stock, 556–558stock splits, 558–559

Dividends in arrears, 551–552Documentation procedures, 344Double-declining-balance method, 435Double-entry system, 49Dunlap, “Chainsaw” Al, 292–293Duties, segregation of, 342–343

EEarnings:

gross, D4statement of, D10

Earning power, 717Earnings management, 300Earnings per share (EPS), 307–308, 712–713Economic entity assumption, 10Effective-interest amortization method,

506–509EFT, see Electronic funds transfersEgypt, ancient, 343Electronic controls, 344, 345Electronic funds transfers (EFT), 352–353Employee earnings record, D8Employee fringe benefits, liabilities for, F5–F8Employee Retirement Income Security Act

(ERISA), F7Employees:

bonding of, 346hiring of, D2

Employee’s Withholding Allowance Certificate(W-4), D6

The End of Work (Jeremy Rifkin), 194Endorsements, restrictive, 350Environmental liabilities, 115EPS, see Earnings per shareEquipment, 428–429, 647

I-4 Subject Index

Equity:stockholders’, 12–13trading on the, 712

Equity method, 601–602ERISA (Employee Retirement Income

Security Act), F7Errors:

on bank statements, 359–360in inventory, 259–261

balance sheet effects, 260–261income statement effects, 259–260

Ethics:in financial reporting, 8–9in personal financial reporting, 25

Exchange of intangible assets, 452–454gain treatment, 453–454loss treatment, 452–453

Expense(s), 51accrued, 106–109administrative, 211defined, 13operating, 210–211prepaid, 98–102, 118–119selling, 211

Expired costs, 300External transactions, 14External users of accounting data, 6Extraordinary operations, 718–720

FFace value, 488

of bonds, 484, 487of notes receivable, 400present value of, 500–502

Factors, 395–396FAFSA form, 25Fair value, 605–607FASB, see Financial Accounting Standards

BoardFederal Bureau of Investigation (FBI), 4Federal Insurance Contribution Act (FICA), D5Federal unemployment taxes, D11–D12Federal Unemployment Tax Act (FUTA), D11FICA (Federal Insurance Contribution

Act), D5FICA taxes:

employer contribution for, D11payroll deduction for, D5–D6

FIFO method, see First-in, first-out methodFinancial accounting, database concept of, 302Financial Accounting Standards Board

(FASB), 9, 294–295, 297, 313Financial calculator, using a, C16–C17Financial statement presentation and analysis:

of intangible assets, 446–447Financial statements, 5, 21–24, 294

analysis of, 308–312, 698–726classified, 305–308for Coca-Cola Company, B1–B4current liabilities on, 480–482and determination of earning power, 717elements of, 297and global economy, 312–313horizontal analysis of, 699–703inventories on:

cost flow methods, 255–257presentation and analysis, 261–262, 264

irregular items on, 717–720long-term liabilities on, 494–495, 497–498for merchandising operations, 209–214

classified balance sheet, 213, 214multiple-step income statement, 209–213single-step income statement, 213, 214

operating guidelines for preparation of, 297for PepsiCo, Inc., A1–A30preparing, from adjusted trial balance,

113–114, 116

preparing, from worksheets, 148, 152, 153and quality of earnings, 721–722, 724–726ratio analysis of, 705–717receivables on, 403–404retained earnings on, 564–566retained earnings statement, 562–563tools for, 699vertical analysis of, 703–705

Financing activities, cash inflow/outflow from,639, 640

direct method, 670–671indirect method, 651–652

Finished goods inventory, 246First-in, first-out (FIFO) method, 252–253, 266Fiscal year, 95Fixed assets, 426. See also Plant assetsFixed-rate mortgages, 493FOB (free on board), 200, 248FOB destination, 200, 248, 249FOB shipping point, 200, 248, 249Ford, Henry, 533–534“For Deposit Only,” 350Forensic accounting, 30Form W-2 (Wage and Tax Statement), D13–D14Form W-4 (Employee’s Withholding Allowance

Certificate), D6Franchises, 445Free Application for Federal Student Aid

(FAFSA) form, 25Free cash flow, 654–655Free on board (FOB), 200, 248Freight costs, 200–201Fringe benefits, liabilities for, F5–F8Full disclosure principle, 301, F3FUTA (Federal Unemployment Tax Act), D11Future value, C3–C7

of an annuity, C5–C7of a single amount, C3–C5

GGAAP, see Generally accepted accounting

principlesGeneen, Harold, 2General journal, 54, E16–E17General ledger (ledger), 57–61Generally accepted accounting principles

(GAAP), 9, 294and allowance method, 389and alternative accounting methods,

721, 722and cash-basis accounting, 95and materiality, 303

Global economy, and financial statement presentation, 312–313

Going concern assumption, 298–299, 431Goods in transit, 248–249Goodwill, 445–446Government, accounting career opportunities

in, 30Government regulation, of corporations, 537Gross earnings, D4Gross profit, 210Gross profit method (for estimating

inventories), 270–271Gross profit rate, 210

HHealth insurance, cost of, 496Held-to-maturity securities, 605Hiring employees, D2Home-equity loans, 567Honor (of notes receivable), 401Horizontal analysis, 699–703

of balance sheet, 700–701of income statement, 701–702of retained earnings statement, 702–703

Human resources (HR), 344, D2

IIASB, see International Accounting Standards

BoardIdentity theft, 364Imprest system, 353Improper recognition, 722Improvements:

additions and, 438land, 427–428

Income:comprehensive, 610, 720pro forma, 722

Income statement, 21, 22classified, 306–308consolidated, 618effects of cost flow methods on, 255–257effects of inventory errors on, 259–260horizontal analysis of, 701–702for merchandising operations, 209–214

multiple-step income statement, 209–213single-step income statement, 213, 214

vertical analysis of, 703–705Income taxes (income taxation):

on classified income statement, 306–307of corporations, 537and depreciation of plant assets, 436effects of cost flow methods on, 257payroll deduction for, D6remitting, D13

Independent internal verification, 344–346Indirect method (of preparing statement of

cash flows), 643–654investing/financing activities, 651–652net change in cash, 652–654operating activities, cash provided/used by,

646–650worksheets, using, 659–664

Industry averages (norms), 699Information, accounting, 295–297Insurance, as prepaid expense, 100Intangible assets, 443–447

accounting for, 443–446amortization of, 443on classified balance sheet, 164copyrights, 444exchange of, 452–454

gain treatment, 453–454loss treatment, 452–453

franchises and licenses, 445goodwill, 445–446patents, 444research and development costs, 446statement presentation/analyis of, 446–447trademarks and trade names, 444

Intercompany comparisons, 699Intercompany eliminations, 615, 616, 618Intercompany transactions, 615, 618Interest, C1–C3

accrued, 107–108on checking accounts, 358compound, C2–C3defined, C1on notes receivable, 400simple, C1–C2

Interest rate, C1Interim periods, 95Internal auditors, 345–346Internal control(s), 340–347

defined, 340and documentation procedures, 344and establishment of responsibility, 341, 342and independent internal verification, 344–346limitations of, 346–347for payroll, D1–D4physical/mechanical/electronic controls, 344, 345and Sarbanes-Oxley Act, 341and segregation of duties, 342–343

Subject Index I-5

Internal Revenue Service (IRS), 436Internal transactions, 14Internal users of accounting data, 6International Accounting Standards Board

(IASB), 9, 313Intracompany comparisons, 699Inventory(-ies), 244–272

classification of, 246–247costing of:

average-cost method for, 254–255,267–268balance sheet effects, 257and consistency principle, 257and cost flow assumption, 251–252FIFO method for, 252–253, 266financial statement effects, 255–257LIFO method for, 253–254, 267lower-of-cost-or-market method for, 258and quality of earnings, 721specific identification method for, 250–251tax effects, 257

days in, 262determining quantities of, 247–249

and ownership of goods, 248–249physical inventory, 247–248

errors in, 259–261balance sheet effects, 260–261income statement effects, 259–260

estimating, 269–272gross profit method for, 270–271retail inventory method for, 271–272

finished goods, 246just-in-time, 247in merchandising operations, 197–199,

219–222periodic inventory system, 198perpetual inventory systems, 197–198,

219–222, 266–269statement presentation and analysis of,

261–262, 264taking, 247–248theft of, 263

Inventory turnover, 261–262, 709–710Investee, 600Investing activities, cash inflow/outflow from,

639, 640direct method, 670–671indirect method, 651–652

Investments, 594–614debt, 598–599purchase of, by corporations, 596–597short- vs. long-term, 608–609stock, 600–605

between 20% and 50%, holdings, 601–602less than 20%, holdings of, 600–601more than 50%, holdings of, 602–603

valuing/reporting of, 605–611, 613available-for-sale securities, 607–608on balance sheet, 608–609on classified balance sheet, 610–611realized/unrealized gain/loss presentation,

609–610, 613trading securities, 605–607

Investment banking, 540Investment portfolio, 600Investments, long-term, see Long-term

investmentsInvoice(s):

purchase, 199, 200sales, 203

Irregular items, 717–720changes in accounting principle, 720comprehensive income, 720discontinued operations, 717–718extraordinary operations, 718–720

IRS (Internal Revenue Service), 436

JJIT (just-in-time) inventory, 247Johnson, Matthew, 715Journal, 54–57Journalizing, 54–55, 67–68, 110–111Just-in-time (JIT) inventory, 247

KKnight, Phil, 4

LLand, 427Land improvements, 427–428Large stock dividend, 556Last-in, first-out (LIFO) method, 253–254, 267LCM (lower-of-cost-or-market), 258Leases, F3–F5

capital, F4–F5operating, F3–F4

Lease liabilities, F3–F5Ledger, see General ledgerLegal capital, 541Letter to the stockholders, A2–A3Leverage, 712Leveraging, 712Liabilities, 12, 472–499

contingent, F1–F3current, 474–482

long-term debt, current maturities of,479–480notes payable, 475–476payroll and payroll taxes payable, 476–478sales taxes payable, 476statement presentation/analysis of, 480–482unearned revenues, 479

in double-entry system, 49for employee fringe benefits, F5–F8environmental, 115lease, F3–F5long-term, 482–495, 497–498

bonds, 482–492, 500–513notes payable, long-term, 492–493statement presentation/analysis of, 494–495,497–498

Licenses, 445LIFO conformity rule, 257LIFO method, see Last-in, first-out methodLimited liability, of corporate stockholders, 535Liquidating dividend, 553Liquidation preference, 552Liquidity, 309–310, 481Liquidity ratios, 706–710

acid-test ratio, 707–708current ratio, 706–707inventory turnover, 709–710receivables turnover, 708–709

Long-term debt, current maturities of, 479–480Long-term debt due within one year, 480Long-term investments, 163, 608, 609Long-term liabilities, 482–495, 497–498

bonds, 482–492, 500–513on classified balance sheet, 166notes payable, long-term, 492–493postretirement benefits as, F8present value of, C12–C15statement presentation/analysis of, 494–495,

497–498Long-term notes payable, 492–493Lower-of-cost-or-market (LCM), 258Lucas, George, 96

MMACRS (Modified Accelerated Cost

Recovery System), 436Mail receipts, 350–351Maker, 398Management (of corporation), 536

Management consulting, as area of publicaccounting, 29

Management’s discussion and analysis(MD&A), A3

Managerial accounting, 6, 29Market interest rate, 486, 488Market value:

book value vs., 102, 572of stock, 541

Marshall, John, 534Matching principle, 95–96, 300Materiality (materiality principle), 303, 438Maturity date (of promissory note), 399MD&A (management’s discussion and

analysis), A3Mechanical controls, 344, 345Medicare, D5n.1Merchandising operations, 194–224

completing the accounting cycle for,206–208adjusting entries, 207closing entries, 207

cost of goods sold in, 216–218financial statements for, 209–214

classified balance sheet, 213, 214multiple-step income statement, 209–213single-step income statement, 213, 214

inventory systems in, 197–199periodic system, 198perpetual system, 197–198, 219–222

operating cycles in, 196–197recording purchases of merchandise in,

199–203freight costs, 200–201purchase discounts, 201–202purchase returns and allowances, 201

recording sales of merchandise in,203–205sales discounts, 205sales returns and allowances, 204–205

Merchandising profit, 210Mintenko, Stephanie, 338–339MNCs (multinational corporations), 312Modified Accelerated Cost Recovery System

(MACRS), 436Monetary unit assumption, 10, 298Mortgage bonds, 483Mortgage loans, calculating, C17Mortgage notes payable, 493Multinational corporations (MNCs), 312Multiple-step income statement, 209–213

NNatural resources, 442–443Net change in cash:

direct method, 671indirect method, 652–654

Net pay, D7Net (cash) realizable value, 389, 400Net sales, 209–210Net worth, 167Noncash activities, significant, 640–641Noncash current assets, changes in, 647–648Nonoperating activities, 211–213No-par-value stock, 542, 544–545Norms, industry, 699Normal balance, 50Notes payable, 475–476Notes receivable, 398–403

computing interest for, 400defined, 386disposing of, 401–402maturity date of, 399recognizing, 400valuing, 400–401

Not-for-profit corporations, 534NSF (not sufficient funds), 358

I-6 Subject Index

OObsolescence, 431Off-balance-sheet financing, F5“Open-book management,” 3Operating activities, cash inflow/outflow from,

639, 640direct method, 666–670indirect method, 646–650

Operating cycles, in merchandising operations,196–197

Operating expenses, 210–211, 300Operating leases, F3–F4Ordinary repairs, 438Organization costs, 538“Other expenses and losses,” 211Other receivables, 386“Other revenues and gains,” 211Outstanding checks, 359Outstanding stock, 548Over-the counter receipts, 349–350

PPaid absences, F6Paid-in capital, 542, 564Paper (phantom) profit, 256Parent company, 602–603Partnerships, 10Par-value stock, 541, 544, 546Passwords, computer, 344Patents, 444Payee, 398Payment date (dividends), 554Payout ratio, 713–714Payroll, D1–D15

defined, D1determining, D4–D7internal control of, D1–D4recording, D8–D10

Payroll and payroll taxes payable, 476–478Payroll deductions, D5–D7

for FICA taxes, D5for income taxes, D6

Payroll register, D8–D9Payroll taxes, 476, D11–D15

federal unemployment taxes, D11–D12FICA, D11filing/remitting, D13–D15recording, D12–D13state unemployment taxes, D12

PCAOB (Public Company AccountingOversight Board), 341

Pension plans, F7–F8P-E ratio, see Price-earnings ratioPercentage-of-receivables basis, 393–394Percentage-of-sales basis, 392–393Periodic inventory system, 198, 219–222

merchandise purchases in, 220–221merchandise sales in, 221–222

Permanent accounts, 150–151, 154–155Perpetual inventory system(s), 197–198

inventory cost flow methods in, 266–269periodic vs., 219–222

Personal annual report, 71Personal financial reporting, ethics in, 25Petty cash fund, 353–355

establishment of, 353making payments from, 353–354replenishment of, 354–355

Phantom (paper) profit, 256Physical controls, 344, 345Pickard, Thomas, 4Plan administrator (pensions), F7Plant and equipment, see Plant assetsPlant assets, 426–441

buildings, 428defined, 426depreciation of, 430–438

computation, 431–432and income taxes, 436methods, 432–436revisions in estimate of, 436–437

determining cost of, 427–430disposal of, 439–441

retirement, 439–440sale, 440–441

equipment, 428–429exchange of, 452–454

gain treatment, 453–454loss treatment, 452–453

expenditures during useful life of, 438land, 427land improvements, 427–428loss on sale of, 647

Post-closing trial balance, 155–157, 159–161Posting, 59–60, 67–68, 110–111Postretirement benefits, F6–F8Preferred dividend, 712Preferred stock, 550–552, 554–555Premium, bonds issued at, 488–490Prepaid expenses (prepayments), 98–102,

118–119Present value, C7–C16

of an annuity, 502–503, C10–C12, C16and bond pricing, 500–505defined, C7of a long-term note or bond, C12–C15and market value of bonds, 486of a single amount, C8–C10, C15–16variables affecting, C7

Present value of 1 factors, C9Price-earnings (P-E) ratio, 307n.4, 713Principal, C1Principle(s) of accounting, 294–295,

299–303cost principle as, 302full disclosure as, 301matching as, 300revenue recognition as, 299–300

Prior period adjustments, 562Private accounting, 29. See also Managerial

accountingPrivately held corporations, 535Profit:

gross, 210as purpose of corporation, 534

Profitability, 310Profitability ratios, 710–714

asset turnover, 710–711earnings per share, 712–713payout ratio, 713–714price-earnings ratio, 713profit margin, 710return on assets, 711return on common stockholders’ equity,

711–712Profit margin (profit margin percentage),

310, 710Pro forma income, 722Promissory notes, 398Property, plant, and equipment, 164. See also

Plant assetsProprietorships, 10Public accounting, 29Public Company Accounting Oversight Board

(PCAOB), 341Publicly held corporations, 534–535Purchase allowances, 201Purchase discounts, 201–202Purchase invoices, 199, 200Purchase returns, 201Purchases, recording, 199–203

discounts, 201–202freight costs, 200–201returns and allowances, 201

Purchases journal, E11–E13Purchasing activities, and segregation of

duties, 342

QQuality of earnings, 721–722, 724–726

and alternative accounting methods, 721–722and improper recognition, 722and pro forma income, 722

Quick (acid-test) ratio, 707–708

RRatio analysis, 699, 705–717

liquidity ratios, 706–710profitability ratios, 710–714solvency ratios, 714–715summary of ratios, 716

Raw materials, 246R&D (research and development) costs, 446Receipts, cash, 348–351

mail receipts, 350–351over-the counter receipts, 349–350

Receivables, 384–408accounts receivable, 386–398

disposing of, 395–398recognizing, 387types of, 386valuing, 388–395

defined, 386notes receivable, 398–403

computing interest for, 400disposing of, 401–402maturity date of, 399recognizing, 400valuing, 400–401

statement presentation/analysis for, 403–404trade, 386

Receivables turnover, 708–709. See alsoAccounts receivable turnover ratio

Recessions, inventory fraud during, 260Recognition, improper, 722Reconciliation, see Bank reconciliationRecord date (dividends), 554Recording process, 46–74

and accounts, 48–53illustrated example of, 61–68for payroll, D8–D10for payroll taxes, D12–D13steps in, 53–61

journalizing, 54–57ledger, transfer to, 57–61transaction analysis, 15–20

and trial balance, 68–70, 72–73Registered bonds, 484Relevance, of accounting information, 296Reliability, of accounting information, 296Reporting:

of cash, 363, 365–366ethics in, 8–9

Research and development (R&D) costs, 446Responsibility, establishment of, 341, 342Restricted cash, 363Restrictive endorsements, 350Retailers, 196Retail inventory method, 271–272Retained earnings, 51, 542–543, 560–565

defined, 560and prior period adjustments, 562restrictions on, 560–561statement of, 562–563statement presentation/analysis of, 564–566

Retained earnings restrictions, 561Retained earnings statement, 21–23, 562–563

horizontal analysis of, 702–703statement presentation/analysis of,564–565, 568

Retirement, of plant assets, 439–440

Subject Index I-7

Return on assets, 311, 711Return on common stockholders’ equity, 311,

566, 711–712Returns and allowances:

merchandise purchases, 201for merchandise sales, 204–205

Revenue(s), 51accrued, 105–106defined, 13sales, 196unearned, 102–103, 119–120, 479

Revenue expenditures, 438Revenue recognition principle, 95, 299–300Reversing entries, 158, 171–173Rifkin, Jeremy, 194Rowling, J. K., 443Rubino, Carlos, 696–697

SSalaries, 108–109, D1, D4Sale(s):

of bonds, 598–599credit card, 396–397net, 209–210of plant assets, 440–441, 647of receivables, 395–396recording, 203–205

discounts, 205returns and allowances, 204–205

Sales activities, and segregation of duties,342–343

Sales invoices, 203Sales journal, E5–E7Sales revenue, 196Sales taxes payable, 476Salvage value, 431, 432Sarbanes-Oxley Act of 2002 (SOX; Sarbox),

8, 29, 341and human resources, 344and identity theft, 364and restatements, 159

Saving, personal, 612SEC, see Securities and Exchange

CommissionSecured bonds, 483Securities and Exchange Commission (SEC),

9, 294, 537Segregation of duties, 342–343Selling expenses, 211Semiannually payable interest, C12, C13Serial bonds, 484Service charges, bank, 357Short-term investments, 608–609Short-term paper, 609n.4Significant noncash activities, 640–641Simple entries, 55Simple interest, C1–C2Single-step income statement, 213, 214Sinking fund bond, 483Small stock dividend, 556Social Security taxes, see FICA taxesSolvency, 311Solvency ratios, 714–715

debt to total assets ratio, 714–715times interest earned, 715

SOX, see Sarbanes-Oxley Act of 2002Special journals, E4–E18

cash payments journal, E13–E15cash receipts journal, E7–E11effects of, on general journal, E16–E17purchases journal, E11–E13sales journal, E5–E7usefulness of, E4

Specific identification method, 250–251Stack, Jack, 2Star Wars, 96Stated value, 542, 544–545

State income taxes, D6Statement of cash flows, 21, 22, 24, 638–671

classification of cash flows on, 639–640direct method of preparing, 644, 665–671

investing/financing activities, 670–671net change in cash, 671operating activities, 666–670

evaluating a company using, 654–655,657–658

format of, 641indirect method of preparing, 643–654

investing/financing activities, 651–652net change in cash, 652–654operating activities, 646–650worksheets, using, 659–664

preparation of, 642–643preparing, from worksheets, 659–664and significant noncash activities,

640–641usefulness of, 638–639

Statement of earnings, D10State unemployment taxes, D12State unemployment tax acts (SUTA), D12Stock:

authorized, 540book value of, 571–572deciding to invest in, 723issuance of, 540–546market value of, 541, 572par vs. no-par-value, 541–542, 544–546preferred, 550–552treasury, 546–550

disposal of, 548–550purchase of, 547–548

Stock certificate, 538Stock dividends, 556–558Stockholders:

financial statement analysis by, 698letter to the, A2–A3limited liability of, 535ownership rights of, 538–539

Stockholders’ equity, 12–13on classified balance sheet, 166return on common stockholders’ equity,

311, 566, 711–712Stockholders’ equity account, 557Stockholders’ equity statement, 565,

570–571Stock investments, 600–605

between 20% and 50%, holdings, 601–602less than 20%, holdings of, 600–601more than 50%, holdings of, 602–603

Stock splits, 558–559Straight-line method, 432–433, 509–513Su, Vivi, 384–385Subsidiary (affiliated) company, 602Subsidiary ledger(s), E1–E4

advantages of, E3defined, E1example, E1–E2

Supplies, as prepaid expense, 99SUTA (state unemployment tax acts), D12

TT account, 48Taking inventory, 247–248Taxes and taxation. See also Income taxes

(income taxation); Payroll taxesas area of public accounting, 29burden of, 478corporate, 537sales taxes payable, 476

Temporary accounts, 150, 154Term bonds, 484Theft, inventory, 263Three-column form of account, 58Time cards, D3

Timekeeping, D3Time periods, and discounting of bonds,

503–504Time period assumption, 94, 298Times interest earned ratio, 495, 715Time value of money, C1–C18

and discounting, C12future value, C3–C7and interest, C1–C3and market value of bonds, 486present value, C7–C16and use of financial calculator, C16–C17

Timing issue(s), 94–96accrual- vs. cash-basis accounting as, 95fiscal/calendar years as, 95recognizing revenues/expenses as, 95–96selection of accounting time period as, 94

Trademarks and trade names, 444Trade receivables, 386Trading on the equity, 712Trading securities, 605–607Transactions, 14Transaction analysis, 15–20Transfer, of corporate ownership rights, 535Transit, goods in, 248–249Transposition errors, 70Treasurer, 536Treasury stock, 546–550

disposal of, 548–550purchase of, 547–548

Trend analysis, see Horizontal analysisTrial balance, 68–70, 72–73

defined, 68limitations of, 69locating errors in, 69–70post-closing, 155–157, 159–161steps in preparation of, 69use of dollar signs in, 70

Trustee (of bond), 484Turnover:

asset, 446–447, 710–711inventory, 261–262, 709–710receivables, 403–404, 708–709

UUncollectible accounts:

allowance method for, 389–394direct write-off method for, 388–389

Underwriting, of stock issues, 540Unearned revenues, 102–103, 119–120, 479Unemployment taxes:

federal, D11–D12state, D12

Unexpired costs, 300Units-of-activity method, 433–434, 442Unsecured bonds, 484Useful life, 101, 431, 432, 438

VValuation:

of accounts receivable, 388–395of notes receivable, 400–401

Vertical analysis, 699, 703–705of balance sheet, 703of income statement, 703–705

Virtual close, 155Vouchers, 351, 352Voucher register, 352Voucher systems, 351–352

WW-2 (Wage and Tax Statement), D13–D14W-4 (Employee’s Withholding Allowance

Certificate), D6Wages, D1Wages and salaries payable, 476Wage and Tax Statement (Form W-2), D13–D14

I-8 Subject Index

Wear and tear, 431Weighted-average unit cost, 254Wholesalers, 196Withholding taxes, 476. See also Payroll taxesWorking capital, 309–310, 481, 707Working capital ratio, 707Work in process, 246

Worksheet(s), 144–154defined, 144for merchandising company, 222–224preparing adjusting entries from, 148, 150,

152, 154preparing consolidated balance sheets from,

616–617

preparing financial statements from,148, 152, 153

preparing statement of cash flows from, 659–664steps in preparation of, 144–152

ZZero-interest bonds, 486

Subject Index I-9

RAPID REVIEWChapter Content

BASIC ACCOUNTING EQUATION (Chapter 2) INVENTORY (Chapters 5 and 6)

Ownership

ADJUSTING ENTRIES (Chapter 3)

7

Prepare financialstatements:

Income statementRetained earnings statement

Balance sheet

5

Journalize and postadjusting entries:

Prepayments/Accruals6

Prepare an adjustedtrial balance

Optional steps: If a worksheet is prepared, steps 4, 5, and 6 are incorporated in the worksheet.If reversing entries are prepared, they occur between steps 9 and 1 as discussed below.

4

Prepare atrial balance

3

Post toledger accounts

2

Journalize thetransactions

1

Analyze businesstransactions

9

Prepare a post-closingtrial balance

8

Journalize andpost closing entries

Type Adjusting Entry

Deferrals 1. Prepaid expenses Dr. Expenses Cr. Assets2. Unearned revenues Dr. Liabilities Cr. Revenues

Accruals 1. Accrued revenues Dr. Assets Cr. Revenues2. Accrued expenses Dr. Expenses Cr. Liabilities

Note: Each adjusting entry will affect one or more income statement accounts and one ormore balance sheet accounts.

Interest Computation

Interest � Face value of note � Annual interest rate � Time in terms of one year

CLOSING ENTRIES (Chapter 4)

Purpose: (1) Update the Retained Earnings account in the ledger by transferring netincome (loss) and dividends to retained earnings. (2) Prepare the temporary accounts(revenue, expense, dividends) for the next period’s postings by reducing their balancesto zero.

Process

1. Debit each revenue account for its balance (assuming normal balances), andcredit Income Summary for total revenues.

2. Debit Income Summary for total expenses, and credit each expense account forits balance (assuming normal balances).

STOP AND CHECK: Does the balance in your Income Summary Account equalthe net income (loss) reported in the income statement?

3. Debit (credit) Income Summary, and credit (debit) Retained Earnings for theamount of net income (loss).

4. Debit Retained Earnings for the balance in the Dividends account and creditDividends for the same amount.

STOP AND CHECK: Does the balance in your Retained Earnings account equalthe ending balance reported in the balance sheet and the retained earningsstatement? Are all of your temporary account balances zero?

ACCOUNTING CYCLE (Chapter 4)

Freight Terms Ownership of goods on public carrier resides with:

FOB Shipping point Buyer

FOB Destination Seller

Perpetual vs. Periodic Journal Entries

Event Perpetual Periodic*

Purchase of goods Inventory PurchasesCash (A/P) Cash (A/P)

Freight (shipping point) Inventory Freight-InCash Cash

Return of goods Cash (or A/P) Cash (or A/P)Inventory Purchase Returns and Allowances

Sale of goods Cash (or A/R) Cash (or A/R)Sales Sales

Cost of Goods Sold No entryInventory

End of period No entry Closing or adjusting entry required

Cost Flow Methods

• Specific identification • Weighted average• First-in, first-out (FIFO) • Last-in, first-out (LIFO)

CONCEPTUAL FRAMEWORK OF ACCOUNTING (Chapter 7)

Bank Books

Balance per bank statement Balance per booksAdd: Deposit in transit Add: Unrecorded credit memoranda from bank

statementDeduct: Outstanding checks Deduct: Unrecorded debit memoranda from

bank statementAdjusted cash balance Adjusted cash balance

Note: 1. Errors should be offset (added or deducted) on the side that made the error.2. Adjusting journal entries should only be made on the books.

STOP AND CHECK: Does the adjusted cash balance in the Cash account equal thereconciled balance?

Characteristics Assumptions Principles Constraints

Relevance Monetary unit Revenue recognition MaterialityComparability Economic entity Matching ConservatismReliability Time period Full disclosure

Going concern Cost

EP-1

INTERNAL CONTROL AND CASH (Chapter 8)

Principles of Internal Control

• Establishment of responsibility • Physical, mechanical, and electronic controls• Segregation of duties • Independent internal verification• Documentation procedures • Other controls

Bank Reconciliation

Assets Stockholders’ Equity+BasicEquation

ExpandedBasic Equation = + – ++ –

Debit/CreditEffects

Liabilities=

Dr.+

Assets

Cr.–

Dr.–

Liabilities

Cr.+

Dr.–

CommonStock

Cr.+

Dr.–

RetainedEarnings

Cr.+

Dr.+

Dividends

Cr.–

Dr.–

Revenues

Cr.+

Dr.+

Expenses

Cr.–

⎧ ⎪ ⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪

⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪ ⎪ ⎪

⎪ ⎪ ⎪ ⎪ ⎪ ⎩

*Items with an asterisk are covered in a chapter-end appendix.

EP-2

PLANT ASSETS (Chapter 10)

Presentation

INVESTMENTS (Chapter 13)

Comparison of Long-Term Bond Investment and Liability Journal Entries

Tangible Assets Intangible Assets

Property, plant, and equipment Intangible assets (Patents, copyrights,trademarks, franchises, goodwill)

Natural resources

Computation of Annual Depreciation Expense

Straight-line

Units-of-activity � Units of activity during year

Declining-balance Book value at beginning of year � Declining balance rate**Declining-balance rate � 1 � Useful life (in years)

Depreciable cost��Useful life (in units)

Cost � Salvage value��Useful life (in years)

Straight-line amortization

Bond interest expense Bond interest paid

Carrying value of bonds Face amount of bonds �at beginning of period � Contractual interest rateEffective interest rate

Bond discount (premium)Number of interest periods

Note: If depreciation is calculated for partial periods, the straight-line and declining-balance methods must be adjusted for the relevant proportion of the year. Multiply the annual depreciation expense by the number of months expired in the year divided by 12 months.

Retained Earnings

Debits (Decreases) Credits (Increases)1. Net loss 1. Net income2. Prior period adjustments for 2. Prior period adjustments for

overstatement of net income Understatement of net income3. Cash dividends and stock dividends4. Some disposals of treasury stock

No-Par Value Par Value

Cash Cash Common Stock Common Stock (par value)

Paid-in Capital in Excess of Par Value

Cash Common Stock Retained Earnings

Cash dividend ↓ No effect ↓

Stock dividend No effect ↑ ↓

Stock split No effect No effect No effect

BONDS (Chapter 11)

Premium Market interest rate � Contractual interest rate

Face Value Market interest rate � Contractual interest rate

Discount Market interest rate Contractual interest rate

Event Investor Investee

Purchase / issue of bonds Debt Investments CashCash Bonds Payable

Interest receipt / payment Cash Interest ExpenseInterest Revenue Cash

Comparison of Cost and Equity Methods of Accounting for Long-Term Stock Investments

Event Cost Equity

Acquisition Stock Investments Stock InvestmentsCash Cash

Investee reports No entry Stock Investmentsearnings Investment Revenue

Investee pays Cash Cash dividends Dividend Revenue Stock Investments


RECEIVABLES (Chapter 9)Methods to Account for Uncollectible Accounts

Direct write-off method Record bad debts expense when the company determines a particular account to be uncollectible.

Allowance methods: At the end of each period estimate the amount of Percentage-of-sales credit sales uncollectible. Debit Bad Debts Expense

and credit Allowance for Doubtful Accounts for thisamount. As specific accounts become uncollectible,debit Allowance for Doubtful Accounts and creditAccounts Receivable.

Percentage-of-receivables At the end of each period estimate the amount ofuncollectible receivables. Debit Bad Debts Expense andcredit Allowance for Doubtful Accounts in an amountthat results in a balance in the allowance account equalto the estimate of uncollectibles. As specific accountsbecome uncollectible, debit Allowance for DoubtfulAccounts and credit Accounts Receivable.

STOCKHOLDERS’ EQUITY (Chapter 12)

No-Par Value vs. Par Value Stock Journal Entries

Comparison of Dividend Effects

Computation of Annual Bond Interest Expense

Interest expense � Interest paid (payable) � Amortization of discount(OR � Amortization of premium)

Effective-interestamortization(preferredmethod)

Debits and Credits to Retained Earnings

Trading Report at fair value with changes reported in net income.

Available-for- Report at fair value with changes reported in the stockholders’ sale equity section.

Trading and Available-for-Sale Securities

EP-3


Prior period adjustments Statement of retained earnings (adjustment of(Chapter 12) beginning retained earnings)

Discontinued operations Income statement (presented separately after“Income from continuing operations”)

Extraordinary items Income statement (presented separately after“Income before extraordinary items”)

Changes in accounting principle In most instances, use the new method in currentperiod and restate previous years results usingnew method. For changes in depreciation andamortization methods, use the new method in thecurrent period, but do not restate previous periods.

PRESENTATION OF NON-TYPICAL ITEMS (Chapter 15)

STATEMENT OF CASH FLOWS (Chapter 14)

Cash flows from operating activities (indirect method)Net incomeAdd: Losses on disposals of assets $ X

Amortization and depreciation XDecreases in noncash current assets XIncreases in current liabilities X

Deduct: Gains on disposals of assets (X)Increases in noncash current assets (X)Decreases in current liabilities (X)

Net cash provided (used) by operating activities $ X

Cash flows from operating activities (direct method)Cash receipts

(Examples: from sales of goods and services to customers, from receipts of interest and dividends on loans and investments) $ X

Cash payments(Examples: to suppliers, for operating expenses, for interest, for taxes) (X)

Cash provided (used) by operating activities $ X

EP-4

RAPID REVIEWFinancial Statements

Order of Preparation

Statement Type Date

1. Income statement For the period ended

2. Retained earnings statement For the period ended

3. Balance sheet As of the end of the period

4. Statement of cash flows For the period ended

Income Statement (perpetual inventory system)

Name of CompanyIncome Statement

For the Period Ended

Sales revenuesSales $ XLess: Sales returns and allowances X

Sales discounts XNet sales $ X

Cost of goods sold XGross profit XOperating expenses

(Examples: store salaries, advertising, delivery, rent, depreciation, utilities, insurance) X

Income from operations XOther revenues and gains

(Examples: interest, gains) XOther expenses and losses

(Examples: interest, losses) X XIncome before income taxes XIncome tax expense XNet income $ X

Income Statement (periodic inventory system)

Name of CompanyIncome Statement


Sales revenuesSales $ XLess: Sales returns and allowances X

Sales discounts XNet sales $ X

Cost of goods soldBeginning inventory XPurchases $ XLess: Purchase returns and allowances XNet purchases XAdd: Freight in XCost of goods purchased XCost of goods available for sale XLess: Ending inventory X

Cost of goods sold XGross profit XOperating expenses

(Examples: store salaries, advertising, delivery, rent, depreciation, utilities, insurance) X

Income from operations XOther revenues and gains

(Examples: interest, gains) XOther expenses and losses

(Examples: interest, losses) X XIncome before income taxes XIncome tax expense XNet income $ X

Retained Earnings Statement

Name of CompanyRetained Earnings Statement


Retained earnings, beginning of period $ XAdd: Net income (or deduct net loss) X

XDeduct: Dividends XRetained earnings, end of period $ X

STOP AND CHECK: Net income (loss) presented on the retained earnings statementmust equal the net income (loss) presented on the income statement.

Balance Sheet

Name of CompanyBalance Sheet

As of the End of the Period

Assets

Current assets(Examples: cash, short-term investments, accountsreceivable, merchandise inventory, prepaid expenses) $ X

Long-term investments(Examples: investments in bonds, investments in stocks) X

Property, plant, and equipmentLand $ XBuildings and equipment $ XLess: Accumulated depreciation X X X

Intangible assets XTotal assets $ X

Liabilities and Stockholders’ Equity

LiabilitiesCurrent liabilities

(Examples: notes payable, accounts payable, accruals,unearned revenues, current portion of notes payable) $ X

Long-term liabilities(Examples: notes payable, bonds payable) XTotal liabilities X

Stockholders’ equityCommon stock XRetained earnings X

Total liabilities and stockholders’ equity $ X

STOP AND CHECK: Total assets on the balance sheet must equal total liabilities andstockholders’ equity; and, ending retained earnings on the balance sheet must equalending retained earnings on the retained earnings statement.

Statement of Cash Flows

Name of CompanyStatement of Cash Flows


Cash flows from operating activitiesNote: May be prepared using the direct or indirect methodCash provided (used) by operating activities $ X

Cash flows from investing activities(Examples: purchase / sale of long-term assets)Cash provided (used) by investing activities X

Cash flows from financing activities(Examples: issue / repayment of long-term liabilities, issue of stock, payment of dividends)Net cash provided (used) by financing activities X

Net increase (decrease) in cash XCash, beginning of the period X

Cash, end of the period $ X

STOP AND CHECK: Cash, end of the period, on the statement of cash flows mustequal cash presented on the balance sheet.

Ratio Formula Purpose or Use

Liquidity Ratios

1. Current ratio Measures short-term debt-paying ability.

2. Acid-test (quick) ratio Measures immediate short-term liquidity.

3. Receivables turnover Measures liquidity of receivables.

4. Inventory turnover Measures liquidity of inventory.

Profitability Ratios

5. Profit margin �N

Net

etin

scaolemse

�Measures net income generated by each dollar of sales.

6. Asset turnover �AvNer

eatg

seaalesssets�

Measures how efficiently assets are used to generate sales.

7. Return on assets Measures overall profitability of assets.

8. Return on common stockholders’ equity

Measures profitability of stockholders’ investment.

9. Earnings per share (EPS) Measures net income earned on each share of common stock.

10. Price-earnings (P-E) ratio Measures the ratio of the market price per share to earnings per share.

11. Payout ratio Measures percentage of earnings distributedin the form of cash dividends.

Solvency Ratios

12. Debt to total assets ratio Measures percentage of total assets provided by creditors.

13. Times interest earned Measures ability to meet interest payments as they come due.

14. Free cash flow Cash provided by operating activities � Measures the amount of cash generated Capital expenditures � Cash dividends during the current year that is available for

the payment of additional dividends or forexpansion.

Income before income taxes and interest expense��

Interest expense

Total debt��Total assets

Cash dividends��

Net income

Market price per share of stock��

Earnings per share

Net income��Weighted average common shares outstanding

Net income��Average common stockholders’ equity

Net income��Average total assets

Cost of goods sold��Average inventory

Net credit sales��Average net receivables

Cash � Short-term investments � Receivables (net)��

Current liabilities

Current assets��Current liabilities

RAPID REVIEWUsing the Information in the Financial Statements

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SPECIMEN FINANCIAL STATEMENTS: PepsiCo, Inc.€¦ · PepsiCo International PepsiCo Beverages North...

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Transcript of SPECIMEN FINANCIAL STATEMENTS: PepsiCo, Inc.€¦ · PepsiCo International PepsiCo Beverages North...