CHAPTER 13
Operating Activities
THINKING BEYOND THE QUESTION
How do we account for operating activities?
Estimation methods can have a major effect on a company’s reported rev-
enues and expenses. If appropriate methods are used, the revenues and
QUESTIONS
Q13-1 Both the income statement and the statement of cash flows report the re-
sults of operating activities. The difference is that the income statement
Q13-2 The income statement is organized to highlight certain information that is
useful to financial statement users. By breaking out specific items sepa-
rately, additional information about the workings of the organization are
revealed. For example, if the company has material amounts of both sales
384 Chapter 13
Q13-3 Your friend is partially right—the income statement is full of estimates,
and it does not reveal either the current cash position or the cash flows of
Q13-4 Title to goods transfers to the buyer at the point named in the freight
terms. Therefore, if goods are sold FOB shipping point, the goods become
the property of the buyer when they are loaded onto the truck (or rail car)
Q13-5 There is a large conceptual difference between a reduction of revenue and
an expense. While it is true that the effect on net income would be identi-
cal, there is more to the issue. Revenue can be defined as the reward that
is earned from serving customers. Sales discounts and sales returns are
Q13-6 Gross profit is affected by two types of transactions: sales and the transac-
tions that create inventory cost. For a merchandiser, inventory cost derives
from just one transaction, a purchase. For a manufacturer, it is more com-
Operating Activities 385
Q13-7 Neither receiving nor paying for the raw materials will affect the current–
year income statement. The materials will be expensed as part of cost of
Q13-8 These goods should not be included as part of Hadley’s inventory at De-
cember 31 because the firm does not own the goods. The ownership of
Q13-9 Yes and no. It depends on what is meant by the “amount” of inventory. If
the issue is the quantity of inventory on hand, such as number of cases,
number of tons, etc., the answer is “no.” GAAP require a physical count at
fiscal year-end to confirm the quantity of goods in inventory. On the other
Q13-10 Most corporations attempt to maximize reported earnings and cash flows
from operating activities. Inventory estimation methods affect reported
earnings directly and cash flows indirectly through taxes on corporate
profits. If a company’s unit inventory costs increase over time, LIFO nor-
mally will result in a greater amount of cost of goods sold than FIFO be-
od, it will sell units out of inventory layers that have a lower unit cost than
current costs. The unit cost of these earlier layers may be much lower if
LIFO has been used than if FIFO has been used because they represent
much earlier acquisitions. Therefore, the company may actually record
lower cost of goods sold using LIFO than using FIFO, resulting in higher
Q13-11 This is because of the mechanics of the LIFO and FIFO methods. Under
LIFO, the most recent costs of inventory purchases are charged off to cost
of goods sold. Older costs are reported as ending inventory. When prices
Q13-12 The lower of cost or market rule requires companies to estimate the re-
placement cost of their inventories. If the replacement cost is below cost,
the inventory must be written down to the lower value. The purpose of this
Operating Activities 387
Q13-13 It is difficult to argue that research and development costs don’t provide
any benefit to future accounting periods. If this were true, companies
would be foolish to make such expenditures. Even casual observation of
Q13-14 The existence of a difference between the two amounts indicates that the
company has preferred stock outstanding. Because of the nature of pre-
Q13-15 Earnings per share numbers can be confusing, with both basic and diluted
earnings presented and with computations based on income before and af-
ter items like discontinued segments, extraordinary items, and effects of
388 Chapter 13
EXERCISES
E13-1 Definitions of all terms are listed in the glossary.
E13-2 Hoffman Electric
Income Statement
Year Ending December 31, 2007
Sales revenue $ 260,772
E13-3 Sales are revenues generated from the sale of goods and services during
a fiscal period.
Other income is income generated by other miscellaneous operating activ-
ities.
Research and development expenses are those associated with the crea-
tion and improvement of products and production processes. GAAP
require these costs to be expensed in the period in which they occur.
Provision for depreciation, depletion, and amortization is the expense
associated with the use of plant assets, natural resources, and intan-
Operating Activities 389
Provision for taxes on income is the amount of tax a company would owe
on its pretax income if this amount of income were reported for tax
(Based on the “Other Topics” section at the end of the chapter)
Minority interests is the portion of income of consolidated subsidiar-
ies attributable to minority stockholders of these subsidiaries. Thus,
Earnings per share is the amount of net income available to common
stockholders divided by the average number of common shares out-
standing during the fiscal period. Alcoa reports earnings per share as
basic and diluted. The diluted value represents earnings available to
common shareholders if all convertible securities were exchanged for
common stock.
E13-4 a. In general, San Miguel should not recognize revenue until:
i. It has completed most of the activities necessary to produce and
sell the goods or services,
390 Chapter 13
In other words, revenue cannot be recognized until the company
has performed those activities that earn it the right to receive pay-
b. San Miguel’s service contracts provide for service over a period of
time. Therefore, service revenue should be recognized as time pass-
E13-5 Amount of gross sales $30,000,000
Sales discounts 900,000
Amount billed 29,100,000
Operating Activities 391
E13-6 a.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Cash
Other
Assets
Contributed
Capital
Retained
Earnings
Accounts Receivable
18,600,000
Calculation of doubtful accounts expense:
Allowance for doubtful accounts,
beginning of 2008 $ 450,000
Account written off (165,000)
Balance after write-off $ 285,000
E13-7 a. The entire amount should be recognized as a sale in April, when the
machine is delivered to the customer and the earnings process is
completed.
b. The cost of the components should be recognized in April, as part of
Sales Revenue
18,600,000
Cash
18,750,000
Accounts Receivable
Accounts Receivable
392 Chapter 13
E13-8 Year 2007 Year 2008
a. Accounts Receivable:
b. Doubtful Accounts Expense:
2007: $4,000,000 × 0.05 $ 200,000
2008: Proof $ 191,600*
c. Allowance for Doubtful Accounts:
E13-9 a. Revenue = $700,000 ($2,000,000 × 35%)
E13-10 a. Revenue = $16,000,000 ($40 million × 40%)
Operating Activities 393
E13-11
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Cash
Other
Assets
Contributed
Capital
Retained
Earnings
2/27
Merchandise
400
E13-12 a.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Cash
Other
Assets
Contributed
Capital
Retained
Earnings
1
Merchandise Inventory
600,000
Accounts Payable
600,000
2
Accounts Receivable
855,000
Sales
3
Merchandise Inventory
Cost of Goods Sold
–491,000
4
Merchandise Inventory
–35,000
Accounts Payable
5
Cash
Accounts Receivable
6
Cash
–565,000
Accounts Payable
–565,000
7
Accounts Receivable
–22,000
Sales Discounts
–22,000
8
–16,000
–16,000
9
Accounts Receivable
–12,000
Totals
103,000
Accounts Payable
Accounts Payable
Cash
Accounts Receivable
625
Sales
Merchandise
Cost of Goods Sold
Cash
Accounts Receivable
394 Chapter 13
b. Net Income
Gross sales revenue $ 855,000
Sales discounts (22,000)
E13-13 The income statement recognition of the events would be in March, when
the sale took place; the income statement effect in the other months is ze-
ro. Both the purchase and the sale should be recorded net of the discount.
Sale—invoice price $ 75,000
E13-14 a. Always false. Sales discounts are not an expense. They do not repre-
sent the use or consumption of resources in generating revenue. In-
stead, sales discounts are a reduction in the amount of revenue that
has been earned. They are similar to other price reductions. In es-
sence, it is revenue that the company never had.
Operating Activities 395
E13-15 a. Beginning inventory 100 units
Purchased (500 + 400) 900
Sold (880)
Ending inventory 120 units
Cost of goods available for sale:
Gross profit: $3,230
($10,560 − $7,330)
LIFO:
Ending inventory = $966
(100 × $8.00) + (20 × $8.30)
396 Chapter 13
b. The highest gross profit results from FIFO because the oldest, lowest
E13-16
(In millions)
Beginning
Inventory
Ending
Inventory
FIFO
$ 2,015
$ 2,575
Because ending inventory would have been higher under FIFO, cost of
You can also use knowledge of the accounting equation (assets = liabili-
E13-17 a. As reported If LIFO had
Income via FIFO been used
Sales revenue $ 60,000,000 $ 60,000,000
Less:
Cost of goods sold 42,000,000 44,000,000
Operating Activities 397
Cash flow via FIFO been used
c. No. Cost of goods sold would have been $2 million higher using LIFO
rather than FIFO. As a result, the company’s net income would have
E13-18 a. Goods were sold to customers on credit.
b. Company records cost of goods sold and decrease of inventory.
c. Cash was collected from customers’ credit purchases.
d. Inventory was purchased on credit.
e. Some of the inventory purchased on credit was returned to the ven-
398 Chapter 13
c. Total cost of goods available for sale = 1,200 + 700 + 1,500 = $3,400
E13-20 a. Total units sold = 8,000 + 2,000 + 5,000 = 15,000
c. Total cost of goods available for sale = 90,000 + 36,000 + 140,000 =
$266,000
E13-21 Merchandise Cost of
Inventory Goods Sold
January 1 balance (550 @ 300) $ 165,000
Operating Activities 399
E13-22
Merchandise Cost of
Inventory Goods Sold
January 1 balance (550 @ 300) $ 165,000
E13-23 a. Earnings per share data distinguish the effect of an extraordinary
b. Basic and diluted earnings per share are the categories specified by
Statement of Financial Accounting Standards No. 128. Basic earnings
per share includes no dilutive securities, so the weighted-average
Income Amount
EPS
Shares
$3,487
$1.16
3,006
(Thousands except per
share)
Income Amount
EPS
Shares
Before extraordinary item
$3,487
$1.00
3,487
c. The extra 500 would come from some kind of security that could turn
into common stock, such as convertible preferred stock, convertible
bonds, or employee stock options.
400 Chapter 13
E13-24 A complete income statement is shown below with each of the require-
ments keyed by letter.
Net operating revenues $ 956,000
Cost of goods sold (312,000)
Selling and administrative expenses (245,000)
E13-25 a. Income from continuing operations, before taxes $ 250,000
Income tax expense (provision for taxes) (75,000)
Income before special items 175,000
Discontinued operations:
Operating Activities 401
E13-26 a. Inventory is expensed as cost of goods sold when it is sold; so this
would be expensed in 2008 rather than 2007.
b. Estimated warranty costs should be expensed in the year of sale, to
PROBLEMS
P13-1 Leafy Green Corp.
Income Statement
For the Month of January 2007
Sales $16,500
Expenses:
Salad ingredients $8,500
P13-2 In general, revenues are recognized in the income statement when the fol-
lowing four criteria have been met:
1. The selling company has completed most of the activities necessary to
produce and sell the goods or services.
402 Chapter 13
b. Each month 1/24 of the subscription price would be recognized.
P13-3 Revenue recognition involves decisions about when revenue is recorded
for financial reporting purposes. This is an important decision because it
affects the amount of revenue reported in specific fiscal years. Revenue
should be recognized when it has been earned. The earnings process typ-
P13-4 A. Accounts receivable, 1/1/2008
($16.5 million + $1.8 million) $ 18,300,000
Sales on credit 56,500,000
Collected from customers (57,900,000)
B. Allowance for doubtful accounts, beginning of 2008 $ 1,800,000
Accounts written off as uncollectible (1,980,000)