Chapter7Revenues,Expenses,andProfit

MultipleChoiceQuestions

1.C2.D3.A4.A5.C6.D7.C8.C9.C10.D11.A12.B

13.C14.B15.D16.C17.B18.D19.A20.C

DiscussionQuestions

1.Distinguishbetweencapitalexpenditureandrevenueexpenditure.Giveexamplesforeachofthem.

Theexpenditurethatwillbenefitseveralaccountingperiodsisconsideredacapitalexpenditure.Accountsoftenusetheverb“capitalize”tomeancharginganexpendituretoanassetaccountratherthananexpenseaccount.Forexample,purchaseofacomputersystemisacapitalexpenditure.

Anyexpenditurethatwillbenefitonlythecurrentperiodorthatisnotmaterialinamountistreatedasrevenueexpenditureandisrecordedinexpenseaccounts.Charginganexpendituredirectlytoanexpenseaccountisoftencalled“expensing”theitem.Forexample,expendituresforordinaryrepairs,maintenance,fuel,andotheritemsnecessarytotheownershipanduseofplantandequipmentaretreatedasrevenueexpenditures.

Abusinessmaypurchasemanysmallitemsthatwillbenefitseveralaccountingperiodsbuthaverelativelylowcosts.Forthereasonsofconvenienceandeconomy,expendituresthatarenotmaterialinamountaretreatedinaccountingperiodsasexpensesofthecurrentperiod.

2.TheIncomeStatementofamerchandisingcompanyincludesamajortypeofcostthatdoesnotappearintheIncomeStatementofaservicecompany.Identifythiscostandexplainwhatitrepresents.

CostofGoodsSoldisthecostincurredbythesellertoacquirethemerchandiseinventoryitsellstocustomers.Companiesdeductcostofgoodssoldfromsalesrevenuetodeterminegrossprofit;oftenreferredtoasgrossmargin.

Inessence,costofgoodssoldisanexpense.However,inmanycases,itisacompany’slargestexpenseandhasasignificanteffectonthefinancialstatementsubtotalsandratiosusedtoevaluatetheliquidityandperformanceofthebusiness.Therefore,itisshownseparatelyfromotherexpensesinthecompany’sIncomeStatement.

3.Ingeneralterms,whatarerevenuesandexpenses?Howaretheyrelatedinthedeterminationofacompany’snetprofitornetloss?

Revenueisthevalueofgoodsandservicesrenderedduringagivenaccountingperiod.Earningrevenuecausesowners’equitytoincrease.Whenabusinessrendersservicesorsellsmerchandisetoitscustomers,itusuallyreceivescashoracquiresanaccountreceivablefromthecustomers.Theinflowofcashandreceivablesfromcustomersincreasesthetotalassetsofthecompany;ontheothersideoftheaccountingequation,owners’equityincreasestomatchtheincreaseintotalassets.Thus,revenueisthegrossincreaseinowners’equityresultingfromoperationsofthebusiness.

Expensesarenon-productrelatedexpendituresofthegoodsandservicesusedupintheprocessofearningrevenue.Expensesareoftencalledthe“costsofdoingbusiness”,thatis,thecostofthevariousactivitiesnecessarytocarryonabusiness.Thesecostsarenecessarytoattractandservecustomersandtherebyearnrevenuebutnoneofthemaredirectlyrelatedtothemanufacturingoftheproducts.Anexpensealwayscausesadecreaseinowners’equity.

4.Whatisthepurposeoftherealizationprinciple?Howisitusedtorecordsalesofmerchandise?

Theprimaryissuerelatedtorevenuerecognitioniswhentorecognizetherevenue.Therealizationprincipleindicatesthatrevenueshouldberecognizedatthetimegoodsaresoldorservicesarerendered.Atthispoint,thebusinesshasessentiallycompletedtheearningprocess,andthesalesvalueofthegoodsorservicescanbemeasuredobjectively.Atanytimepriortothesale,theultimatevalueofthegoodsorservicessoldcanonlybeestimated.Afterthesale,theonlystepthatremainsistocollectfromthecustomer,whichisusuallyarelativelycertainevent.

Companiesrecordsalesrevenueincompliancewiththerevenuerealizationprinciple.Typically,companiesearnsalesrevenuewhenthegoodsaretransferredfromthesellertothebuyer.Atthispoint,thesalestransactioniscompletedandthesalespriceisestablished.

5.Ifthepurchaserisnotsatisfiedwiththegoodsreceived,theymayreturnthegoodstotheseller.Howwillthesellerrecordthereturnedgoods?

Ifthepurchaserisnotsatisfiedwiththegoodshereceived,hemayreturnthegoodstotheseller.Thatis,theselleracceptsgoodsbackfromapurchaser(areturn).ThesellerusestheaccountentitledSalesReturnsandAllowancetorecordthesetransactions.

Theentriestorecordcreditforreturnedgoodsinvolved(1)anincreaseinSalesReturnsandAllowanceandadecreaseinAccountsReceivable,and(2)anincreaseinMerchandiseInventoryandadecreaseinCostofGoodsSold.

6.Distinguishbetweensalesallowancesandsalesdiscounts.Howtoprepareentriesforeachofthem?

Ifthepurchaserisnotsatisfiedwiththegoodshereceived,hemayaskforasalesallowance.Thatis,thesellergrantsareductioninthepurchaseprice(anallowance)sothatthebuyerwillkeepthegoods.Thesellergivesthebuyerareductionintheamountthebuyerowes,duetotheproductthatlackstheagreed-uponquality,butisstillusablebythebuyer.Becausenoproductwasreturned,thereisonlyonesetofjournalentriestomake,thatis,anincreaseinSalesReturnsandAllowanceandadecreaseinAccountsReceivable.NoneofwhichpertaintoinventoryorCostofGoodsSold.

Toencouragecustomerstomakeearlypaymentsforpurchasesonaccount,sellersoftenoffercashdiscounts,suchas2/20,n/30.Thisiscalledbythesellerasalesdiscount.Asalesdiscountisbasedonthegross(full)invoicepricelessreturnsandallowance,ifany.Ifthecustomermadepaymentbeforethediscountperiodexpired,thesellerwouldreceivethecashdeductingsalesdiscountfromgross(full)invoicepricelessreturnsandallowance,ifany.

7.XiaoLibelievesthatrevenuesfromcreditsalesmaybeearnedbeforetheyarecollectedincash.Doyouagree?Explain.

Iagree.Revenueshouldberecognizedatthetimegoodsaresoldorservicesarerendered.Atthispoint,thebusinesshasessentiallycompletedtheearningprocess,andthesalesvalueofthegoodsorservicescanbemeasuredobjectively.Afterthesale,theonlystepthatremainsistocollectfromthecustomer.

8.Whatareextraordinaryitems?Whyareextraordinaryitemsnecessarytoshowtoinvestors?

Extraordinaryitemsareeventsandtransactionsthataredistinguishedbytheirusualnatureandbytheinfrequencyoftheiroccurrence.

Theextraordinaryitemsareusedtoshowinvestorswhatthenetincomewouldhavebeeniftheotherrevenue/expenseandgain/losshadnothappened.Therefore,investorsmustcarefullyexaminethefinancialstatementsforafirm’snon-operatingactivities.

9.Whatareretainedearnings?Howisprofitrelatedtoretainedearnings?

Retainedearningsarecomposedofnetincomeacompanyretainsinthebusiness,representinganincreaseinowners’equitythathasaccumulatedovertheyearsfromprofitableoperations.Thebalanceofretainedearningsisapartofthestockholders’claimonthetotalassetsofthecorporation.

ThebalanceoftheRetainedEarningsaccountrepresentsthetotalnetincomeofthecorporationovertheentirelifetimeofthebusiness,lessallofthedividendsgiventoitsstockholders.

Acompanymayretainthenetincomeearnedinthebusiness,oritmaydistributeittostockholdersthroughpaymentofcashdividends.Anetincomeincreasesretainedearningsandanetlossdecreasesretainedearnings.Bothcashandstockdividendsdecreaseretainedearnings.

10.Duringthecurrentyear,companyAearnedagrossprofitof$890,000,whereascompanyBearnedagrossprofitofonly$650,000.Bothcompanieshadnetsalesof$1,300,000.DoesthismeanthatcompanyAismoreprofitablethancompanyB?Explain.

No,itdoesnotmeanthatcompanyAismoreprofitablethancompanyB.ForanIncomeStatement,profitcanbedividedintofourlevels:(1)grossprofit(oftencalledgrossmargin),(2)incomefromoperations,(3)incomebeforetaxes,and(4)netincome.Grossprofitistheresultofsubtractingcostofgoodssoldfromsalesrevenue.Incomefromoperationsistheresultofsubtractingoperatingexpensesfromgrossprofit.Basedonincomefromoperations,incomebeforetaxesisobtainedbybeingadjustedbyotherrevenuesandexpenses,andgainsandlosses.Onceincometaxispaid,theremainderisnetincome.Thatis,

Netincome=grossprofit(netsalesminuscostofgoodssold)–operatingexpenses+/-gainsorlosses-incometax

Netincomeisawidelyappliedfinancialratiotomeasureprofitability.Inthissample,bothcompanieshadnetsalesof$1300000,butwedonotknowtheoperatingexpenses,gainsand/orlossesofthetwocompanies,wecannotknowthenetincomesofthetwocompanies.Therefore,wecannottellwhichcompanyismoreprofitable.

Problems

Problems7-1

InMarch2019,thefollowingtransactionswerecarriedoutbycompanyA:

1.OnMarch2,companyAsold$6,500ofgoodstocompanyBonaccountintermsof2/15,n/30.Thecostofthegoodsis$4800.

Mar.2

AccountsReceivable

6,500

Sales

6,500

TorecordcreditsaletoCompanyB.

Mar.2

CostofGoodsSold

4,800

MerchandiseInventory

4,800

ToRecordcostofmerchandisesoldonMar.2.

2.OnMarch10,companyAreceivedreturnedgoodsof$2,500,thecostis$1800.

Mar.10

SalesReturnsandAllowance

2,500

AccountsReceivable

2,500

TorecordcreditgrantedtoCompanyBforreturnedgoods.

Mar.10

MerchandiseInventory

1,800

CostofGoodsSold

1,800

TorestoreMerchandiseInventoryaccountwiththecost

ofmerchandisereturnedbycompanyB.

3.OnMarch15,companyBmadethepayment.

Mar.15

Cash

SalesDiscount

3,920

80

AccountsReceivable

4,000

Collecteda$4,000accountsreceivablefromcompanyB

whotooka2%discountforearlypayment:adecreaseinearningsof$80.

Problems7-2

OnMay1,companyA’sboardofdirectorsdeclaredacashdividendof$0.12percommonshareanda10%sharedividendtoshareholdersofrecordonMay15.OnMarch1,therewere98000sharesoutstandingandnoadditionalshareswereissuedduringMay,thesh