Chapter 1 INTRODUCTION Accounting, defined Accounting has been defined as follows: Accounting is a service activity.

Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decision. 1 There are four important aspects of the definition. First, accounting is a service activity. Second, its basic function is to provide quantitative information which is financial in nature. Third, the information relates to economic entities. Fourth, the information is useful in making economic decisions, or reasoned choices among alternative courses of action. Divisions of Accounting For purposes of study, accounting may be divided into two major fields, namely, financial accounting and managerial accounting. Financial accounting is concerned primarily with the provision of information to persons outside the business. The persons outside the business, or the external users, include the creditors, investors, the government, the employees and their unions, the customers, and the general public. These external users have various needs which must be satisfied by the business through the provision of financial accounting information. Basically, the information provided to these external users consists of the balance sheet, the income statement, and the statement of changes in financial position. These statements show the financial position, the results of operations, and the changes in financial position of a business. Managerial accounting is concerned primarily with the provision of accounting information to managers inside the business. Management needs information in making various decisions with regard to the conduct of the business.

__________________________________ 1 Statement of financial Accounting Standards No. 1, "basic concepts and Accounting Principles Underlying Financial Standards of Business Enterprises" (Manila: Accounting Standards Council, July, 1983), par. 1.

Distinctions between Financial and Managerial Accounting Financial accounting and managerial accounting may be distinguished as follows: 1. Financial accounting information is primarily for external users; managerial accounting information is for internal users, or managers; 2. The development of financial accounting information is governed by generally accepted accounting principles; managerial accounting information is dictated by the needs and preferences of management, not necessarily by generally accepted accounting principles; 3. Financial accounting information, which consists primarily of the balance sheet, the income statement, and the statement of changes in financial position, is general-purpose financial information, which is intended to satisfy the common needs of various users; managerial accounting information is special purpose-information which is directed to a specific need or problem of management; 4. Financial accounting reports are mandatory, they being required by laws, rules, and accounting standards; managerial accounting reports are discretionary on the part of management; 5. Managerial accounting reports include more nonmonetary information like number of units sold, hours worked, etc. than financial accounting statements; 6. Financial accounting information is historical in nature; managerial accounting information is more oriented towards the future; 7. Financial accounting places more emphasis on the accuracy of accounting data; managerial accounting sacrifices some degree of precision to obtain more timely information; 8. Managerial accounting relies more heavily than financial accounting on other disciplines such as statistics, mathematics, operations research, economics, and the behavioral sciences; 9. Financial accounting information is prepared following generally fixed procedures and forms; managerial accounting reports do not result from fixed and repetitive procedures and are not presented in standardized forms; 10. Financial accounting is concerned with the business as whole; managerial accounting is also concerned with the various segments of a business. Similarities between Financial and Managerial Accounting The separation of accounting into financial and managerial accounting is made only for purposes of study and as a matter of convenience. In actual practice, no clear line separates financial accounting and managerial accounting. Managerial and financial accounting relies on the same accounting system for information. The accounting system that generates information for external reporting purposes also provides the same information for managerial uses. The information provided in the financial statements, for example, is also utilized by management for various purposes. The information may be used by management to evaluate operating performance, to control costs, and to plan future operations.

The concepts which underlie the preparation of financial accounting information also apply to managerial accounting. An example is the concept of relevance. The provided accounting information, whether to external users or to management, should be relevant to the needs of the users. Areas of Accounting Practice In terms of accounting practice, accounting can be divided into three major areas: public accounting, private accounting, and government accounting. An accountant will find himself in any of these three areas should he decide to practice accounting. An accountant who enters into public accounting practice renders his services for a fee to the general public without discrimination. He is not an employee of a particular person or entity but is an independent professional, just like any other professional offering his services to the public. There are three areas of public accounting practice: Auditing, taxation, and management advisory services. Auditing is the traditional area of accounting practice and constitutes the primary function of an independent practitioner. It is concerned with an examination of the financial statements of a business for the purpose of expressing an independent opinion on the fairness and reliability of the financial statements. External users rely on the opinion of an external auditor in using the financial statements of a business. Taxation is an area of public accounting practice which is concerned with the preparation of income tax returns of a business client and providing expert advice on matters involving taxes. Management advisory service is the most recent field of public accounting practice. It embraces a wide range of advisory services including such matters as systems design and installation, organization, personnel, finance, production, internal control, operations research, and special studies. It is also referred to as management consultancy. In contrast to a public accountant, a private accountant (or industrial accountant) is employed by, or works for a single business or enterprise. A private accountant may be engaged in any of the following areas: 1. Financial or General Accounting 2. Cost Accounting 3. Internal Auditing 4. Tax Accounting 5. Management Accounting 6. Financial Forecasting or Budgeting 7, Design of Accounting Systems Financial accounting or general accounting is concerned with recording of the business transactions of a firm and preparing periodic financial statements from the accounting

records for external users. Cost accounting is a phase of accounting which is primarily concerned with the collection, accumulation, reporting, and interpretation of cost data related to the manufacture of products, manufacturing processes, operations, or functions. Cost accounting is particularly applicable to manufacturing enterprises. Internal auditing is concerned with the evaluation of the efficiency of operations and the determination of adherence to company policies and procedures by all departments and divisions of a business. Internal auditing must be distinguished from external auditing. The internal auditor provides services to a single person or entity and is regarded as an employee of the person or entity. An external auditor provides services to several clients and is not an employee of his clients. The primary function of an internal auditor is evaluating internal control, whereas the primary function of an external auditor is expressing an opinion on the financial statements with regard to their conformity to generally accepted accounting principles. Tax accounting may be present in a large business. The tax accountant for a single enterprise is involved in the same functions as those engaged in by a public accountant, which are providing advice on matters involving taxes and preparing income tax returns for the business. Management accounting is concerned with the provision and use of accounting information for managerial purposes. Financial forecasting, or budgeting, deals with the preparation and use of budgets. A budget is a plan of the activities of a business for a future period of time which is expressed in figures. The design of accounting systems relates to the forms, records, procedures, reports, equipment, and personnel which are used to process business transactions and which constitute an accounting system. An accounting system may be a manual accounting system, which is maintained purely by hand, a mechanical system, or a sophisticated system using electronic processing equipment. The accountant who designs, installs, and monitors an accounting system is also called a systems analyst. Government accounting practices, is concerned with the accounting for the revenues and expenditures of the national and local government agencies, government schools and colleges, hospitals, and other government-owned and controlled corporations. A large number of auditing, which is concerned with determining whether financial statements of government agencies are presented in accordance with generally accepted accounting principles as well as government laws and regulations. Government auditing also involves determining whether resources of an entity are being economically and efficiently used, or whether the objectives set by higher authorities (for example, the legislature) are being achieved.

An area of accounting practice that is similar to government accounting is accounting for non-profit institutions. Non-profit institutions refer to such institutions as colleges and universities, churches, hospitals, and charitable institutions. These institutions are not established primarily for profit but for other purposes. Planning Managerial accounting information is useful to management in relation to the functions of planning, control, and decision-making. Planning involves the setting down of objectives and the determination of the means to achieve those objectives. The first step in planning is setting down the objectives of the business. What is the objective of the business? Is it o be a leader in the industry? Is it to achieve a desired profit? Is it to attain a certain market share? Is it to earn a desired rate of return? There are several possible objectives that are available to a business. Management must choose the objectives which it deems desirable. Once objectives have been established, the means to attain the objectives must be identified. There are also several ways of utilizing or deploying resources to achieve a given objective. An evaluation of these alternatives is necessary in order to obtain the best possible use of limited resources. There are several types of plans to guide future action. The plan may cover a short period of time, like a year, or may extend several years into the future. The first is called a short-range plan while the second is a long-range plan. Business usually engages in both types of planning. Plans may also vary according to coverage. Plans may be prepared for an entire business or only for a specific segment, project, or activity of the business. Planning for the entire business is referred to as period planning or budgeting, whereas planning for a project or activity is referred to as project planning. Plans are necessary not only to guide future action. They also constitute goals or standards with which future performance can later be compared. Control The process of comparing actual results with plans to ascertain if results conform to the plans and taking corrective action if there are deviations is referred to as control. Control involves the comparison of actual results with expected results, determining the magnitude of deviations, ascertaining the causes of significant deviations, and taking corrective action. The comparison of actual results with plans is made possible by the preparation of performance reports. These reports show the plans, actual results, deviations, and may also include the causes of the deviations and the persons responsible for them. If actual results conform to plans, no further action is necessary. However, if actual results differ materially

from plans, an investigation should be undertaken to ascertain the causes of differences. The investigation may reveal deficiencies, weaknesses, errors, or inefficiencies in the implementation of the plans. The determination of the causes of deviations from plans provides the basis for taking corrective action, which is the essence of control. If weaknesses or deficiencies are the causes of deviations, future performance can be improved. On the other hand, if they investigation reveals that plans are unrealistic or unattainable, the plans can be revised or modified. Decision-making Decision-making is the process of evaluating alternative courses of action so that a final choice can be made. Decisions also relate to the various functions of the business such as production, sales, finance, and personnel. A decision to manufacture a part is a production decision; a decision to raise prices of products is a sales decision; and a decision to lease a facility rather than buying it is a financing decision. With respect to the time involved, a decision may be a short-term decision or a long-term decision. Short-term decisions are normally routine, operating decisions whereas long-term decisions are non-routine, investment decisions. An example of short-term decision is whether to sell or process further an intermediate product, an example of a long-term decision is whether to construct a plant. The process of arriving, at a decision may be briefly outlined as follows: 1. Identifying the problem or opportunity for improvement, 2. Identifying alternative courses of action, 3. Weighing the consequences of each alternative, and 4. Reaching a final decision.

The role of the Accountant in Business In a single business, several functions are being performed such as production, sales, finance, accounting, personnel, and research. The nature of these function are different and may be classified as line functions or staff functions. If a function is directly related to the attainment of the objectives of the business, it is called a line function. If the function serves or supports a line function, it is a staff or service function. A service function is only indirectly related to the objectives of a business. In most businesses, the objectives are producing and selling goods to customers. Thus, the line functions are production and sales. Accounting, finance, and personnel are staff functions since they support production and sales.

In the case of a public accounting firm, the rendering of accounting services is the objective. Hence, the provision of accounting services is a line function. Persons who occupy line positions have the authority to make decisions, while persons occupying staff positions render advice to line positions. The chief accountant in a business, who is also called controller, performs a staff function. His primary function is to provide information, render advice, and give recommendations to persons in line positions, or those who make the decisions. The controller does not make the decision himself, nor can he compel decision-makers to accept his recommendations. For example, the controller cannot command executives of line departments to implement a certain accounting procedure as he does not have line authority over them. If he believes that the adoption of an accounting procedure, he submits his recommendations to an operating executive like the president. If the operating executive accepts his recommendations, then the operating executive can direct the executives of the line departments to implement the accounting procedure. The president can direct the executives of the line departments to implement the accounting procedure. The president can direct the executives of the line departments to adopt the new accounting procedure as he has the line authority. Controller may be delegated functional authority by an operating executive to implement a new accounting procedure. In this case, the controller can install the new procedure and instruct direct the line departments to comply with the new procedure. When the controller is delegated functional authority, he is not acting in a purely staff capacity. The function of a controller varies from company to company. In a small company, he may be responsible only for keeping the books, recording transactions, and reporting them to higher executives. An example of an organization chart for a fairly large company is illustrated in the following page. The illustration shows that the controller is responsible for general accounting, cost accounting, management accounting, systems design and EDP, budgeting, tax planning, and internal auditing. The controller, like the treasurer, occupies a staff position. He reports directly to the vicepresident of finance, who in turn is accountable directly to the president. Finance and personnel are service functions. The line functions are production and sales.

President

Vice-Pres. For Production

Vice-Pres. For Sales

Vice-Pres. For Finance

Vice-Pres. For Personnel

Controller

Treasurer

General Accounting

Cost Accounting

Management Accounting

System Design and EDP

Budgeting

Tax Planning

Internal Auditing

Figure 1.1 Organization Chart

APPENDIX MANAGAMENT ADVISORY SERVICES

Management advisory services by independent accounting firms have been described by the American Institute of Certified Public Accountants as follows: Management advisory services by independent accounting firms can be described as the function of providing professional advisory (consulting) services, the primary purpose of which is to improve the client's use of its capabilities and resources to achieve the objectives of the organization. This can relate to such areas as: - The management functions of analysis, planning, organizing, and controlling - The introduction of new ideas, concepts, and methods to management - The improvement of policies, procedures, systems, methods, and organizational relationships - The application and use of managerial accounting, control systems, data processing, and mathematical techniques and methods, and - The conduct of special studies, preparation of recommendations, development of advice and technical assistance in their implementation. In providing this advisory service, the independent accounting firm applies an analytical approach and process which typically involve: - Ascertaining the pertinent facts and circumstances - Seeking and identifying objectives - Defining the problem or opportunity for improvement - Evaluating and determining possible solutions, and - Presenting findings and recommendations, and following the client's decisions to proceed, the independent accounting firm may also be involved in - Planning and scheduling actions to achieve the desired results, and - Advising and providing technical assistance in implementing, in combination with knowledge and expertise in such areas as : - Organization and management methods - Office and management functions - Systems and procedures - Data processing methods - Quantitative methods (mathematics, statistics, etc.) and - Financial Management

to produce solutions such as: - A management information system - A sales reporting system - A cost accounting system - A work measurement program - Improved production control - An organization plan with statement of duties and responsibilities, or - An electronic data processing system. 2 General Standards Applicable to Management Advisory, Services The following standards have been adopted for the guidance of practitioners in the field of management advisory services. 1. Management advisory services are to be performed by persons having adequate training and experience in both the application of the analytical approach and process, and in the subject matter under consideration. 2. In all matters relating to a management advisory services assignment, an independence in mental attitude is to be maintained by the member and his staff. 3. Due professional care is to be exercised in the performance of management advisory services. 3

QUESTIONS 1. What is the basic function of accounting? 2. Distinguish between financial accounting and managerial accounting 3. Give similarities between financial accounting and managerial accounting 4. What are three basic or primary financial statements? 5. Who are the primary users of financial accounting information? 6. State differences between the type of information provided by managerial accounting and financial accounting. 7. Why is financial accounting governed by generally accepted accounting principles?

______________________________ 2 Statement on Management Advisory Services no. 1, "Tentative Description of the Nature of Management Advisory services by Independent Accounting Firms" (New York: American Institute of Certified Public Accountants, 1969), par. 4. 3 Statement on Management Advisory Services no. 2, "Competence in Management Advisory Services" (New York: American Institute of Certified Public Accountants, 1969), par. 11.

8. What are the different areas of accounting practices? 9. Distinguish the public accountant from the private accountant. 10. What is the primary function of an external accountant? 11. What is Management Advisory Services? 12. What is the relationship of managerial accounting and management advisory services? 13. What management functions are served by management accounting information? 14. Define planning. What are the different types of planning? 15. What is meant by control? What is the relationship of planning and control? 16. What is meant by decision making? 17. Distinguish between a line function and staff function. 18. Is accounting a line function or a staff function? 19. What is a controller? 20. How is a controller distinguished from a treasurer?

Chapter 2 STATEMENT OF CHANGES IN FINANCIAL POSITION

Objectives of the Funds Statement The statement of changes in financial position is one of the primary financial statements required to be presented in corporate annual reports to stockholders. The other two statements are the balance sheet and the income statement. The balance sheet shows the financial position of a business as of a given date, whereas the income statement shows the results of operations for a period of time. The statement of changes in financial position has the following objectives: 1. To summarize the financing and investing activities of a business, and 2. To explain the changes which have occurred in the financial position of the business over a period of time. The statement of changes in financial position is intended to provide information that is not ordinarily found in the income statement and balance sheet of the business. This additional information would be helpful to creditors, investors, and other external users in better understanding the activities of the business and in making more informed decisions. Some of the items of information that are disclosed in a statement of changes in financial position are: 1. Net changes in working capital items 2. Amount of funds provided by normal operations 3. Other specific sources of funds like borrowing 4. Funds used for specific purposes such as payment of dividends and acquisition of noncurrent assets 5. Other significant financing and investing activities like conversion of preferred stock or long-term debt into common stock. Concepts of Funds The term "funds" is susceptible of many definitions. It has been used to refer to the following: 1) Cash and cash equivalents 2) Cash and temporary securities 3) All monetary assets (cash, temporary investments, and receivables) 4) Net monetary assets (monetary assets less current monetary liabilities) 5) Working capital (current assets minus current liabilities) 6) All financial resources

The all financial resources concept is the broadest concept. It includes all significant financing and investing activities of the business regardless of whether cash or working capital is directly affected. For example, the issuance of capital stock in direct exchange for land affects neither cash nor working capital of the business but this transaction represents a significant financing and investing activity, and hence, it is embraced under the all financial resources concept. Generally accepted accounting standards do not require a specific concept to be adopted in the preparation of a statement of changes in financial position. Thus, a cash concept, a working capital concept, or other concept of funds may be used by the standards also require that significant financing and investing activities be disclosed in the statement regardless of the concept employed. In effect, what is required to be presented is a financial resources concept applied on the cash, working capital, or other concept. The funds statement has been variously referred to in the past as the where-got, where-gone statement of sources and applications of funds, and the statement of resources provided and applied. The statement is now popularly referred to as the statement of changes in financial position. Sources of Information These funds statement can be prepared from the following information: 1) The balance sheets of the current year and the immediately preceding year 2) Income statement data 3) Explanatory data with respect to changes in balance sheet accounts. In the absence of explicit information, it may also be necessary to make logical inferences or assumptions with regard to changes in accounts. For example, if the balance of the Retained earnings account increased during the year, it could logically be inferred or assumed that the account balance increased due to the transfer of net income to Retained Earnings. Approaches to the Preparation of Funds Statement There are two basic approaches to the preparation of a funds statement: a work sheet approach and a T-account approach. Both approaches are simply devices to aid in the preparation of a funds statement. They help organize and assemble the information in an orderly and systematic manner and thus facilitate the preparation of the funds statement. The drawback to the use of these approaches, however, is that they are time-consuming and tedious. This is especially true in the case of a work sheet. Thus, where transactions and adjustments are not numerous, worksheets or complete sets of T-accounts are not necessary and may be dispensed with. The use of a few T-accounts, for example, would be adequate in many cases.

Illustrative Problem To illustrate the preparation of a funds statement, assume the following data for the San Pedro Company: Balance Sheet December 31 Assets 19A 19B Cash P 12,200 P 19,750 Accounts receivable P 32,400 P 34,000 Less allowance for Bad debts 2,600 29,800 2,800 31,200 Merchandise Inventory 34,000 40,600 Prepaid expenses 1,600 1,400 Investments 16,000 6,000 Office equipment P 10,500 P 9,500 Less accumulated Depreciation 1,500 9,000 1,050 8,450 Buildings P 150,000 P 150,000 Less accumulated Depreciation 30,000 120,000 35,000 115,000 Land 100,000 130,000 Total assets P 322,600 P 352,400 Liabilities & Stockholders Equity Accounts Payable Notes Payable Accrued expenses Bonds payable -10% Less discount on bonds Preferred stock Common stock, P10 par Premium on common stock Retained Earnings Total Liabilities and stockholders equity P 24,500 5,000 3,000 P 50,000 2,250 47,750 50,000 100,000 5,000 87,350 P 322,600 P 50,000 2,000 P 25,000 4,000 2,550 48,000 50,000 150,000 10,000 62,850 P 352,400

Income Statement For the Year Ended December 31,19b Sales Less cost of goods sold Gross Profit Less operating expenses (including depreciation of P 5,150) Net operating income (carried forward) P 168,000 98,000 P 68,000 54,550 P 13,650

Net operating income (brought forward) Other revenues (gains) and expenses (losses): Interest expense Loss on sale of equipment Gain on sale of investments Net Income before taxes Less Income Tax Net Income

P 13,650 P 5,250 900 P 6,150 2,500

3,650 P 10,000 3,500 P 6,500

Additional Information: 1) Investments costing P 10,000 were sold for P 12,500. 2) Office equipment with a cost of P 5,000 and accumulated depreciation of P 600 was sold for P 3,500. Additional equipment was acquired during the year. 3) Land was acquired during the year in exchange for 2,500 shares of common stock. The land was recorded at P 30,000, its fair market value. 4) The 10-year, 10% bonds were issued on January 1, 19A at 95. Amortization of bond discount for the year was P 250. 5) Cash dividends of P 5,000 were paid during the year on preferred stock. 6) Stock dividends of 20% were declared and paid on the outstanding common stock at the end of the year. On the date of declaration, the common stock had a fair market value of P 12 per share. 7) Accounts receivables of P 600 were written off during the year against the allowance for bad debts. Working Capital Concept When funds are defined as working capital, the transactions of the business are analyzed in terms of their effect on working capital, that is, on current assets and current liabilities. The transactions of the business which affect working capital are classified either as sources of working capital or uses of working capital. Some transactions of the business do not have any effect on working capital. These transactions are ignored in the preparation of the funds statement. However, certain transactions which do not directly affect working capital may represent significant sources and uses of funds and therefore should be disclosed in the statement in accordance with the all financial resources concept. A statement of changes in financial position employing the working capital concept is prepared as follows: 1) Determine the increase or decrease in net working capital during the year. 2) Analyze the changes in nonworking capital accounts to determine their effect on working capital.

Determining Change in Working Capital The first step in preparing a statement of changes in financial position applying the working capital concept is to determine the net change in working capital during the period. This is done by comparing the current assets and current liabilities of the current year and the immediately preceding year. All increase in a current asset or a decrease in a current liability represents an increase in working capital; a decrease in a current asset or an increase in a current liability represents a decrease in working capital. Some changes in current assets and current liabilities merely involve changes within the working capital pool and thus gave no effect on the working capital. An example is the collection of accounts receivable. The collection of accounts receivables increases cash but also decreases accounts receivable, which are both components of working capital. The net effect of these changes on working capital is therefore zero. The effect of changes in current assets and current liabilities on the working capital is shown in a schedule of changes in working capital. The schedule for the San Pedro Company is presented below. Schedule of Changes in Working Capital December 31 Current assets: Cash Accounts receivable Allowance for bad Debts Merchandise inventory Prepaid expense Total current Assets Current liabilities: Accounts payable Notes payable Accrued expenses Total current Liabilities Working capital Increase in working capital 19A P 12,200 32,400 ( 2,600) 34,000 1,600 19B P 19,750 34,000 ( 2,800) 40,000 1,400 P 92,950_ Working Capital Increase Decrease P 7,750 1,600 P 200 6,600 200

P 77,600

P 24,500 5,000 3,000 32,500 P 45,100

P 25,000 4,000 2,550 31,550 P 61,400

500 1,000 450

___ P 17,200

16,300_ P 17,200

The schedule indicates that the working capital of the San Pedro Co. increased by P 16,300 during 19B.

Analyzing Changes in Nonworking Capital Accounts After computing the change in working capital for the period, the causes of the change in working capital can be determined. This involves an analysis of the noncurrent or nonworking capital accounts. A transaction which increases working capital represents a source of working capital, while a transaction which decreases working capital represents a use of working capital. The sources of working capital are decreases in noncurrent assets and increases in noncurrent liabilities and in owners equity. The sources of working capital may be classified as follows: 1) Income from operations 2) Issuance of capital stock 3) Issuance of long-term debt 4) Sale of investments, plant assets, and other noncurrent assets. On the other hand, the uses of working capital arise from increases in noncurrent assts and decreases in noncurrent liabilities and owners equity. 1) Loss from operations 2) Retirement or acquisition of treasury stock 3) Retirement of long-term debt 4) Acquisition of noncurrent assets, investments, and other noncurrent assets 5) Payment of dividends. There are no fixed rules regarding the order in which noncurrent accounts are to be analyzed. However, it is more convenient to tart with an analysis of the Retained Earnings account since this account includes the net income from operations, which is the first item to be presented in the funds statement. An analysis of the nonworking capital accounts of the San Pedro Company is given below. (a) Retained Earnings Retained earnings decreased by P 24,500. The decrease in Retained Earnings is accounted for as follows: Net Income, per income statement P 6,500 Deduct: Cash dividends paid P 6,000 Stock dividends paid ( 20% x 12,500 shares x P10) 25,000 31,000_ Decrease in retained earnings P 24,500 *The Retained Earnings was debited for the par value of the stock dividends issued. In the funds statement, the net income would be presented as a source of working capital from operations. The cash dividends paid would be presented as a use of working capital. The stock dividends issued would not be reported in the statement as they do not affect working capital.

(b) Investments There was a decrease in the investment account of P 10,000. The decrease was caused by the sales of the investments which had a carrying value of P 10,000. The proceeds from the sale were P 12,500. In the funds statement, the proceeds of P 12,500 would be reported as a source of working capital. The gain of P 2,500 would be deducted from net income. (c) Office equipment The office equipment decreased by P 1,000. The decrease resulted from the sale of the equipment costing P 15,000 and the purchase of additional equipment. The cost of the equipment purchased is P 4,000, calculated as follows: Office equipment, ending balance P 9,500 Add: Cost of equipment sold 5,000_ P 14,000 Deduct: Office equipment, beginning balance 10,000_ Cost of equipment purchased P 4,000 The cost o equipment purchased would be presented as a use of working capital. On the other hand, the proceeds from the sale of the equipment would be presented as a source of working capital. Since the equipment, which had a book value of P 4,400, was sold for P 3,500, there was a loss on the sale amounting P 900. The loss of P 900 would be reported as an addition to the net income. (d)Accumulated Depreciation-office Equipment The balance of this account decreased by P 450 during the year. This decrease resulted from the cancellation of the accumulated depreciation of P 600 related to the equipment sold and he provision for depreciation during the year in the amount of P 150, which is determined as follows: Accumulated depreciation, ending balance P 1,050 Add: Decrease in accumulated depreciation 600 due to sale of equipment P 1,650 Deduct: accumulated depreciation, beginning balance 1,500 Provision for depreciation P 150 The provision for depreciation of P 150 would be added to net income in the funds statement. The cancellation of the accumulated depreciation on the equipment sold does not have any effect on orking capital. (e) Buildings There was no change in the buildings account during the year. (f) Accumulated depreciation-buildings The accumulated depreciation on the buildings increased by P 5,000 during the year. In the absence of any information concerning this change, it can be assumed that the increase was bought about by the provision for depreciation during the year.

The depreciation of P 5,000 would be added to the net income to arrive at the working capital provided by operations. (g) Land The land account increased by P 30,000 as a result of the acquisition of land in direct exchange for common stock. The exchange of common stock for the land does not have any effect on working capital. However, this transaction is a significant financing and investing activity which would have to be reported in the funds statement in accordance with the all financial resources concept of funds. Thus, the acquisition of land would be reported as a use of working capital and the issuance of stock would be reported in under the sources of working capital. The amount to be reported would be the fair market value of the land, which is P 30,000. (h) Bonds Payable This account remained unchanged during the year. (i) Discount on Bonds Payable The discount on bonds payable decreased by P 250, which represents the bond discount amortization for the year. The bond discount amortization is added back to net income in the funds statement since it did not involve any working capital outlay. (j) Preferred Stock No change in this account occurred during the year. (k) Common Stock The common stock account increased during the year by P 50,000. This increase was brought about by the issuance of common stock in exchange for land and the issuance of stock dividends. The total par value of the common stock issued is computed as follows: Common stock issued in exchange for land P 25,000 (2,500 shares x P 10) Common stock dividends issued (12,500 shares x 20% x P 10) 20,000 Total par value of stock issued P 50,000 The common stock issued in exchange for the land is presented as an application of funds. The common stock issued as dividends have no funds significance ad would be ignored in preparing the funds statement. (l) Premium on Common Stock The balance of this account at the end of the year increased by P 5,000. The increase resulted from the issuance of common stock at a premium. The premium is equal to the difference between the fair market value of the land and the par value of the common stock issued in exchange for the land. The premium on common stock is added to the par value of the stock issued in arriving at the total amount to be presented as the amount provided by the issuance of common stock.

The statement of changes in financial position showing the sources and uses of working capital is presented below. San Pedro Company Statement of Changes in Financial Position For the Year ended December 31, 19B Working capital was provided by: Operations: Net Income Add: items not requiring working capital: Loss on sale of equipment Depreciation Bond discount amortization Deduct: items not providing working capital: Gain on ale of investments Working capital provided by operations Sale of investments Sale of office equipment Issuance of common stock to purchase land Total working capital provided Total working capital was applied to: Payment of cash dividends Purchase of office equipment Purchase of land through issuance of Common stock Total working capital applied Increase in working capital

P P 900 5,150 250

6,500

6,300_ P 12,800 2,500_ P 10,300 12,500 3,500 30,000_ P 56,300

P 6,000 4,000 30,000_ 40,000_ P 16,300

The schedule of changes in working capital is an integral part of the funds statement applying the working capital concept and should be presented after the above statement. Worksheet Approach The steps under the worksheet approach may be outlined as follows: 1) Enter the balances of the noncurrent accounts in the worksheet. Accounts with debt balances are listed first followed by accounts with credit balances. The account balances for the preceding year are entered under the first column while the corresponding figures for the current year are entered under the fourth column. 2) For each year, compute the totals of the accounts with debit balances and the accounts with credit balances. The difference between the totals of the accounts with debit balances and accounts with credit balances represents the working capital for each year and is entered as the balancing figure in the worksheet. 3) Enter the adjustments and reconciling transactions under the second and third columns of the work sheet. Accounts representing sources and uses of working capital are listed and described at the bottom part of the worksheet as necessary.

The worksheet for the statement of changes in financial position of the San Perdro Company is presented below. San Pedro Company Work Sheet for Statement of Changes in Financial Position (Working Capital Basis) For the year ended December 31, 19B Items Debits Working capital Investments Office equipment Buildings Land Discount on Bonds Total Credits Accumulated deprequipment Accumulated depr. buildings Bonds payable Preferred stock Common stock Premium on common stock Retained earnings Total Balance Dec. 31 19A 45,100 16,000 10,500 150,000 100,000 2,500 323,850 Balance Dec. 31 19B 61,400 6,000 9,500 150,000 130,000 2,000 358,900

(1) (e)

Adjustments Debit Credit 16,300 (d) 10,000 4,000 (f) 5,000

(i) 30,000 (k) 250

1,500 30,000 50,000 50,000 100,000

(f)

600

(g) (h)

150 5,000

1,050 35,000 50,000 50,000 150,000

(c) (j) (j) (a)

25,000 25,000 5,000 6,500

5,000 87,350 328,850

(b) 6,000 (c) 25,000

10,000 62,850 358,900

Working Capital was provided by: Operations: Net income Gain on sale of investment Loss on Sale of equipment Depreciation-office equipt. Depreciation-Buildings Bond Discount amortization Sale of investments Sale of office equipment Issuance of stock for land Working capital was applied to: Payment of cash dividends Purchase of equipment Purchase of land Increase in working capital Total

(a)

6,500 (d) 2,500

(f) 900 (g) 150 (h) 5,500 (k) 250 (d) 12,500 (f) 3,500 (j) 30,000 (b) (e) (i) (l) 140,700 6,400 4,000 30,000 16,300 140,700

The following entries, which are entered only on the work sheet, provide the explanations for the adjustments and reconciling items in the next worksheet: (a) Funds provided by operations- net income P 6,500 Retained earnings P 6,500 To record funds provided by income from operations. (b) Retained Earnings P 6,000 Funds applied to cash dividends P 6,000 To record funds applied to payment of cash dividends. (c) Retained Earnings P 25,000 Common Stock P 25,000 To record stock dividends (d) Funds provided by sale of investments P 12,500 Investments P 10,000 Net income-gain on sale of investments 2,500 To record funds provided by sale of investments. (e) Office Equipment P 4,000 Funds applied to purchase of equipment P 4,000 To record funds applied to purchase of office equipment. (f) Funds provided by sale of office equipment P 3,500 Accumulated depreciation-Off. Equip. 600 Net income-loss on sale of Equip. 900 Office equipment P 5,000 To record funds provided by sale of Office equipment. (g) Net income-depreciation P 150 Accumulated depreciationOff. Equip. P 150 To record funds provided by sale of office equipment. (h) Net income-Depreciation P 5,000 Accumulated depreciation-Bldgs. P 5,000 To record depreciation on buildings. (i) Land P 30,000 Funds applied to purchase of land\ through issuance of stock P 30,000 To record funds applied to purchase of land.

(j) Funds provided by issuance of stock Common stock Premium on common stock To record funds provided by issuance of stock to purchase land. (k) Net income-Bond discount Discount on bonds payable To record amortization of bond discount. (l) Working Capital Increase in working capital To record increase in working capital.

P 30,000 P 25,000 5,000

250 P 250

P 16,300 P 16,300

Working Capital Provided by Operations The primary source of working capital is operations. The working capital provided by operations can be computed based on the income reported by the business. Since the net income does not reflect changes in the working capital, adjustments to the net income are necessary. The adjustments to be made to net income to arrive at the working capital provided by operations are shown below. Net income P xxx Add charges not requiring outlay of working capital xxx_ P xxx Deduct credits not providing working capital xxx_ Working capital provided by operations P xxx The firs type of adjustments to the net income consists of the charges not requiring the outlay of working capital. These charges were recognized in the determination of the net income. However, since these charges did not involve any working capital outlay they are added back to net income. Examples of charges that are to be added back to net income are 1) Depreciation expense 2) Loss on sale of assets 3) Amortization of intangibles 4) Amortization of bond investment premiums 5) Amortization of bond payable discounts 6) Increase in deferred income taxes 7) Share in the loss of a subsidiary The second type of adjustment to net income is the credits not involving any inflow of working capital. These credits were recognized in arriving at net income but did not involve any increase in working capital. Hence, they are subtracted from net income to arrive at the working capital provided by operations. Examples of credits which are to be deducted from et income are the following: 1) Gain on sale of assets 2) Amortization of bond investment discounts 3) Amortization of bond payable premiums 4) Realized portion of deferred revenues

5) Decrease in deferred income taxes 6) Share in subsidiary income Some charges or credits to net income are not related to changes n noncurrent assets or equities. They result from changes in current assets or current liabilities. Examples are provisions for bad debts and gains or losses from the sale of marketable securities. While these charges or credits do not require or generate cash, they nevertheless increase or reduce working capital. Hence, they are not added back to or subtracted from net income in obtaining the working capital provided by operations. Loss from operations if a business suffers a loss from operations, it would still be necessary to make adjustments for charges or credits not requiring or providing working capital. If the net adjustment for nonworking capital charges and credits exceeds the loss, a working capital provided by operations would still result. However, if the net adjustment is less than the loss from operations, a working capital applied to operations should be reported under the application or uses of working capital section of the funds statement. Extraordinary items Extraordinary items are unusual and nonrecurring items. Examples are loss from a major catastrophe like an earthquake, loss from expropriation of property, and gains or losses from the early extinguishment of debt. When extraordinary items are found in the income statement of a business, the working capital provided by operations should start with the income before extraordinary items instead of the net income. The working capital provided by or applied to the extraordinary item should be presented separately from the working capital provided by operations. The extraordinary item can be presented, for example, immediately after the working capital provided by operations, assuming that the extraordinary item represents a source of working capital. Working Capital Provided by OperationsAlternative Procedure________________ The working capital provided by operations can be obtained through an alternative method. The working capital provided by revenues or sales is first determined. Then the working capital applied to various operating cost are computed. The difference between the working capital provided by sales and the working capital applied to the various operating costs represents the working capital provided by operations.

Using the same data of the San Pedro Company, the working capital provided by operations is computed as follows: Sales Deduct: Cost of goods sold Operating expenses (excluding depreciation of P 5,150) Interest expense ( P 5,250 less discount of P 250) Income taxes Working capital provided by operations P 168,000 P 99,800 49,000 5,000 3,500

P 157,000_ P 10,300

Non working Capital Changes Affecting Working Capital The changes in nonworking capital accounts, or noncurrent accounts, may be classified as follows: 1) Changes in noncurrent accounts which affect working capital 2) Changes in noncurrent accounts which do not affect working capital. Changes in noncurrent accounts which affect working capital may be summarized as follows: Change Increases in noncurrent assets (Debits) Decreases in noncurrent assets (Credits) Increases in noncurrent equities (Credits) Decreases in noncurrent equities (Debits) Effect

Decrease working capital Increase working capital Increase working capital Decrease working capital

Decreases in noncurrent assets and increases in noncurrent equities increase working capital and therefore represent sources of working capital. Increases in noncurrent and assets and decreases in noncurrent equities decrease working capital and therefore represent uses of working capital. Cash is the item of working capital that is usually affected by changes in noncurrent accounts. Other current assets and current liabilities are also affected by changes in noncurrent accounts. Examples of changes in noncurrent accounts which affect working capital items other than cash are the following: 1) Declaration of a cash dividend. This transaction decreases working capital since a current liability is created when cash dividends are declared. The payment of the liability, on other hand, does not affect working capital. 2) Reclassification of a long-term liability o a current liability. This transaction reduces working capital because current liabilities are increased. 3) Reclassification of a noncurrent marketable security to a current marketable security or viceversa. This increases or decreases working capital since current assets are either increased or decreased.

Nonworking Capital Not Affecting Working Capital Changes in noncurrent accounts which do not affect working capital may be grouped into the following types: 1) Changes in noncurrent accounts which represent adjustments to net income in arriving at the working capital provided by operations. Examples are depreciation, amortization of intangibles, loss on sale of assets, and other charges or credits to net income which do not affect working capital. These items are added to or subtracted from net income because they do not require or provide working capital. 2) Changes in noncurrent accounts which affect other noncurrent accounts and which have no funds significance. Examples are: a) Write-off of fully depreciated asset b) Issuance of stock dividends and stock splits c) Appraisal of assets d) Appropriation of retained earnings e) Accounting errors affecting only noncurrent items. These Changes, having no funds significance, are not required to be disclosed in the funds statement. 3) Changes in noncurrent accounts which represent significant financing and investing activities which are required to be disclosed in the funds statement even if they do not increase or decrease working capital or cash. Examples are: a) Acquisition of noncurrent assets in exchange for stocks or long-term debt b) Acquisition of assets in exchange for other assets c) Conversion of preferred stock or long-term debt in common stock d) Settlement of debt or liquidation of ownership interests through the transfer of long-term assets e) Properties received as gifts or donations Cash Concept of Funds When funds are defined as cash, changes in balance sheet accounts are analyzed in terms of their effect on cash. The analysis of noncurrent accounts follows the same procedures employed under the working capital concept of funds. The analysis, however, should be extended to include changes in current assets and current liabilities. The consideration of changes in current assets and current liabilities is necessary since changes in current assets and current liabilities affect cash. In arriving at the cash provided by operations, two approaches may be used, namely:

1) The adjusted net income method, and 2) The receipts and disbursements method Under the first method, change in current assets and current liabilities are added to or deducted from net income. Decreases in current assets and increases in current liabilities are to be added to net income. Increases in current assts and decreases in current liabilities are to be subtracted from net income. A statement of changes in financial position for the San Pedro Company applying the cash concept is shown below. San Pedro Company Statement of Changes in Financial Position For the Year Ended December 31, 19B Cash was provided by: Operations: Net Income Items to be added to net income: Depreciation Loss on sale of equipment Bond discount amortization Decrease in repaid expenses Increase in accounts payable Items to be subtracted from net income: Gain on sale of investments Increase in accounts receivable (net) Increase in merchandise inventory Decrease in notes payable Decrease in accrued expenses Cash provided by operations Sale of investments Sale of office equipment Issuance of common stock to purchase land Total Cash provided Cash was applied to: Purchase of office equipment Payment of cash dividends Purchase of land through issuance of stock Total cash applied Increase in Cash

P P 5,150 900 250 200 500

6,500

7,000 P 13,500

2,500 1,400 6,600 1,000 450

11,950 1,550 12,500 3,500 30,000 P 47,550 P

4,000 6,000 30,000 P 40,000 7,550

When the cash concept of funds is used, a separate schedule of changes in working capital is not necessary since the statement already shows the changes in current assets and current liabilities. Receipts and Disbursements Method The adjusted income method of obtaining the cash provided by operations represents a convenient and practical method. However, it fails to disclose information on the specific sources and uses of cash provided by or applied to operations.

The receipts and disbursements method shows the details of cash flow provided by operations. The items in the income statement, which are stated on the accrual basis, are converted into a cash basis. The conversion of revenues and expenses from an accrual to a cash basis is made possible by first relating current assets or current liabilities to individual revenue and expense items in the income statement. The following examples illustrate the relationships that exist between current items in the balance sheet and items in the income statement. Accounts receivable - related to Sales Merchandise inventory- related to Cost of Goods Sold Accounts payable- related to Purchases Prepaid expenses- related to Operating Expenses Accrued expenses- related to operating Expenses Income tax payable- related to Income Taxes Expense Some current items, such as marketable securities, nontrade receivables and payables, cash dividends payable, and bank loans payable, may be assumed to be unrelated to operations and therefore shown as other sources or uses of cash. The procedures for converting revenues and expenses from the accrual to the cash basis are illustrated below using the data for the San Pedro Company. (1) Computation of cash provided by sales. Sales Add: Accounts receivable, beginning Deduct: Accounts receivable, end Write-off of accounts receivable Collections on sales (2) Computation of Payments for merchandise: Cost of goods sold Add: Merchandise Goods available for sale Deduct: Merchandise inventory, beginning Cost of purchases Add: Accounts payable, beginning Notes payable-trade, beginning Deduct: Accounts payable, end Notes payable-trade, end Cash payment for merchandise (3) Computation of payments for operating expenses: Operating expenses Add: Prepaid expenses, end Accrued expenses, beginning Deduct: Prepaid expenses, beginning Accrued expenses, end Depreciation Bad debts Payments for operating expenses P 34,000 600

P 168,000 32,400 P 200,000 34,600 P 165,000 P 99,800 40,600 P 140,000 34,000 P 106,400 P 24,500 5,000 25,000 4,000 29,500 P 135,900 29,000 P 106,000 P P 1,400 3,000 P P 1,600 2,550 5,150 800 P 54,000 4,000 58,950

10,100 48,850

(4) Computation of payment for interest: Interest expense P 5,250 Less bond discount amortization 250 Cash paid for interest P 5,000 (5) Payment for income tax expense Since there is no liability for income taxes, the income tax expense under the accrual basis and the cash basis is the same, which is P 13,500. The cash provided by operations can be presented in the funds statement as follows: Cash was provided by: Operations: Receipts-Sales P 165,000 Payments-Cost of goods sold P 106,900 Operating expenses 48,850 Interest expense 5,000 Income taxes 3,000 164,250 Cash provided by operations P 1,550 A more simplified procedure for converting revenues and expenses from the accrual to cash basis can be performed by simply relating net changes in the balances of current assets and current liabilities to individual revenue and expense items. The procedures can be stated as follows: Change Procedure Increase in current assets Deduct from related revenues and add to related expenses Decreases in current assets Add to related revenues and Deduct from related expenses Increase in current liabilities Add to related revenues and deduct from related expenses Decrease in current liabilities Deduct from related revenues and add to related expenses Applying the above rules to the data of the San Pedro Company, we get the following results: (1) Sales P 168,000 Deduct: Increase in accounts receivable P 1,600 Write-off of accounts receivable 600 2,200 Collections on sales P 165,000 (2) Cost of goods sold P 99,000 Add increase in inventory 6,600 Cost purchases P 106,400 Add decreases in notes payable-trade 1,500 Deduct increase in accounts payable ( 500) Cash payment for merchandise P 106,900

(3) Operating expenses Add decrease in accrued expenses

54,550 450 55,000

P Deduct: Decrease in prepaid expenses Depreciation Bad debts Payment for operating expenses P 400 5,150 800 P

6,150 48,850

APPENDIX The T-Account Approach The following are the steps under the T-account approach: 1) Determine the net change in working capital for the period 2) Enter the net change in a working capital account 3) Determine the net change in each noncurrent or nonworking capital account and post the net changes to the T-accounts 4) Enter all transactions in the T-accounts. Transactions affecting working capital are entered in the Working Capital account 5) Prepare the statement of changes in financial position from the Working Capital account A working capital account is prepared to summarize the transactions affecting working capital. Increases in working capital are entered on the debit side of the account and decreases are entered on the credit side. The net change in working capital during the period is entered at the top of the T-account on the debit side if it is an increase and on the credit side if it is a decrease. A line is drawn below the amount of net change across transactions to be posted to the account. The working capital T-accounts can be prepared to have four sections: Sources-Operations, Sources-Others, Applications-Operations, and Applications-Others. An illustration of a working Capital T-account is shown below. Working Capital Net Change (Increase) Sources-Operational: (Decrease) Applications-Operations:

Sources-Others:

Applications-Others:

Net change in nonworking capital accounts is determined from the following equation: Beginning balance Increases = Ending Balance Decreases Ending Balance Beginning Balance = Increases Decreases Net Change = Increases Decreases

The net change in an account is simply the difference between the ending and beginning balances. The net change is also equal to the difference between the increase and decreases in the account. The net change in an account is posted to the debit side or credit side of the T-account depending on the nature of the account. Net increases in asset accounts and net decreases in liability and equity accounts are entered on the debit side of the T-accounts. Net decreases in asset accounts and net increases in liability and owners equity accounts are entered on the credit side of the T-accounts. The net change in an account is posted at the top of the T-account and is separated from the transactions by a horizontal line drawn across the T-account. Transactions affecting the different accounts are posted to the proper side of the T-accounts below the net changes. The normal net changes and the increases and decreases in the different accounts are shown below. Asset Accounts Net Change (increase)

Increases

Decreases

Liability accounts Net change (Increase)

Decreases

Increases

Owners Equity account Net Change (Increase)

Decreases

Increases

It is oftentimes necessary to find an unknown item is an account. In such case, the following procedures may be followed: (1) Enter the net change in the account. (2) Enter all known items (increase and decreases) in the account

(3) Enter the unknown item in the account as x. (4) Find the unknown item using the following equation of the account: Net Change = Increases Decreases To illustrate the T-account approach, the data for the San Pedro Company given in the main txt is used. The net changes in the working capital and nonworking capital accounts have been computed and are posted at the top of the proper T-accounts. The following entries are the bases for the postings to the T-accounts. (1) Working capital-operations P 6,500 Retained earnings P 6,500 working capital provided by income from operations. (2) Retained earnings 6,600 Working capital-others 6,000 working capital applied to cash dividends. (3) Retained earnings 25,000 Common stock 25,000 Stock dividends. (4) Working capital-others 12,500 Investments 10,000 Working capital-operations 2,500 Sale of investments at a gain. (5) Office equipment 4,000 Working capital-others 4,000 Purchase of equipment. (6) Working capital-others 3,500 Accumulated depreciation-office equipment 600 Working capital-operations 900 office equipment 5,000 Sale of office equipment at a loss. (7) Working capital-others 150 Accumulated depreciation-office equipment 150 Depreciation on building. (8) Working capital-Operations 5,000 Accumulated depreciation-buildings 5,000 Depreciation on building. (9) Land 30,000 Working capital-Others 30,000 Purchase of land

(10) Working capital-Others Common stock Premium on common on stock Issuance of stock for land. (11) Working capital-Operations Discount on bonds payable Amortization of bond discount. Working Capital Net change P 16,300

P 30,000 P 25,000

250 250

Sources-Operations: 1. Net income 6,500 6. Loss on sale of equipment 900 7. Depn.-equipt, 150 8. Depn-bldg. 5,000 11. Discount amort. 250 Sources-Others: 4. Sale of investments 12,500 6. Sale of equipt. 3,500 10. Issuance of stock 30,000

Applications-Operations: 4. Gain on sale of investment

2,500

Applications-Others: 2. Payment of cash dividends 6,000 5. Purchase of equipment 4,000 9. Purchase of land 30,000

Investments Net change

P10,000

4. Sale of investments 10,000 Office Equipment Net change 5. Purchae of equipment 4,000 6. Sale of equipment

P 1,000 5,000

Accumulated depreciation-office equipment Net change P 450 6. Sale of equipt. 600 7. Depreciation 150

Accumulated depreciation-building Net change 8. Depreciation Land Net change P 30,000

P 5,000 5,000

9. Purchase of land 30,000 Discount on Bonds Net change

250

11. Discount amortization 250 Common Stock Net change

P 50,000 25,000 25,000

3. Stock dividends 10. Issuance of stock Premium on Common Stock Net change

5,000 5,000

10. Issuance of stock Retained Earnings P 24,500 1. Net income

Net change

2. Cash dividends 6,000 3. Stock dividends 25,000

6,500

QUESTIONS 1. What does a statement of changes in financial position show? 2. What are the various concepts of funds? What concept is required under generally accepted accounting standards? 3. What is meant by the all financial resources concept of funds? Give examples of transactions which are regarded as sources and uses of funds even if they do not affect cash or working capital. 4. In preparing a statement of changes in financial position, what information is required? 5. What are the two approaches that may be used in the preparation of changes in financial position?

6. What is working capital? How is working capital provided by operations determined? 7. Give examples of charges to income which do not require the use of working capital. 8. Give examples of credits to income which do not provide working capital. 9. Is an extraordinary item included in the working capital provided by operations? 10. How is a loss from operations presented in a statement of changes in financial position? 11. What are the major sources and uses of working capital other than operations? 12. How do changes in noncurrent accounts affect working capital? 13. Give examples of changes in noncurrent accounts which have no funds significance. 14. Is a schedule of changes sin net working capital an integral part of the statement of changes in financial position? 15. What are the differences between a funds statement prepared under the working capital concept and one prepared under the cash concept? 16. How do changes in current assets and current liabilities affect cash? 17. What are the two approaches that may be used in deriving the cash provided by operations? What are the advantages of each approach?

EXERCISES 1. From the following information of the Pearl Co., prepare a statement of changes in financial position on a working capital basis: Short-term bank borrowings Sale of marketable securities Net income Depreciation Loss o n sale of equipment Proceeds from sale of equipment Issuance of common stock in exchange for equipment Purchase of equipment Declaration of cash dividends Interest received in advance Loss from inventory decline to market Increase in inventory P 40,000 28,000 75,000 10,000 4,000 35,000 50,000 50,000 30,000 8,000 3,000 9,000

2. From the following information obtained from the record s of the Oriental Co., prepare a statement of changes in financial position on a cash basis for the year ended December 31, 19D: Proceeds from issuance of bonds Discount on bonds payable Increase in inventories Decrease in prepaid expenses Issuance of long term note to purchase equipment Purchase of equipment Decrease in accounts receivable Purchase of treasury stock Increase in accounts payable Decrease in accrued expenses Depreciation Amortization of patents Gain on sale of equipment Proceeds from sale of equipment Net income Declaration of stock dividend Investment in bonds P 60,000 6,000 38,000 10,000 45,000 45,000 30,000 32,000 26,000 18,000 21,000 16,000 7,000 42,000 60,000 24,000 100,000

3. The working capital of the Dacanay Co. at the end of year 3 increased by P 600,000. Selected information from the records of the company is available as follows: December 31 Year 2 Year 3 Long-term investments P 2,000,000 P 2,500,000 Equipment, net 3,400,000 4,000,000 Capital stock 5,000,000 6,500,000 Retained earnings 2,600,000 2,800,000 Net income recorded during the year was P 500,000. Depreciation for the year was P 100,000. Required: Prepare a statement of changes in financial position showing the sources and uses of working capital. 4. The balances of selected accounts of the Rosita Company as of December 31, 19C are given below. Discount on bonds payable P 4,000 Marketable securities 20,000 Allowance for bad debts 2,000 Unearned rental income 9,000 Notes payable (long-term) 30,000 Prepaid insurance 5,000 Investment in subsidiary company 40,000 Land held for future use 60,000 Accounts payable 15,000 Inventory 28,000 Cash 7,000 Accounts receivable 12,000

Interest payable Deferred income tax (noncurrent) Bonds payable

6,000 8,000 50,000

Required: What was the amount of working capital of the Rosita Co. on December 31, 19C. 5. State the effect of the following transactions on (a) working capital and (b) cash. The answer in each case is either an increase, a decrease, or no effect. a) Declared a cash dividend payable the following year. b) Payment of cash dividends previously declared during the preceding year. c) Write off of an uncollectible account d) Issuance of a 2 for 1 stock split. e) Retirement of a bond through sinking fund. f) Exercise of stock rights by existing stockholders. g) Reclassification of a noncurrent marketable security to current marketable security. h) Reclassification of a current marketable security to noncurrent marketable security. i) Amortization of a bond investment premium. j) Payment of accounts payable at a discount. k) Collection of accounts receivable at a discount. l) Recording of depreciation. m) Sale of temporary investment. n) Loss on sale of equipment o) Collection of accounts receivable. p) Purchase of merchandise on account. q) Payment of previously recorded accounts payable. r) Conversion of preferred stock into common tock. s) Acquisition of land in exchange for capital stock. t) Recording provision for bad debts. u) Sale of merchandise on account. v) Payment of prepaid rent (debited to Rent expense) 6. Indicate how each of the following transactions would be reported in a statement of changes in financial position prepared on a working capital basis. a) Acquisition of land in exchange for a long term debt. b) Declaration of a stock dividend. c) Borrowing from a bank to augment working capital. d) Amortization of bond payable premium. e) Appropriation of retained earnings for bonded indebtedness. f) Redemption of preferred stock. g) Conversion of bonds into preferred stock. h) Change in accounting for fixed assets from accelerated depreciation method to straight line method.\ i) Recording provision for bad debts. j) Appraisal of land. k) Exchange of old equipment for a new equipment. l) Sale of current marketable securities at a loss.

7. From the following data, compute (a) the working capital provided by operations, and (b) cash provided by operations. Net income Increase in dividends payable Decrease in stock subscriptions receivable Income tax refund (due to prior period adjustments) Decrease in taxes payable Depreciation Amortization of goodwill Uncollectible accounts expense Increase in bank loans payable Increase in accounts receivable (net) Receipt of cash dividends Decrease in unearned interest income Decrease in prepaid expense P 40,000 13,000 4,000 15,000 5,000 9,000 8,000 2,000 10,000 20,000 14,000 6,000 12,000

8. Determine from the following data (a) the working capital provided by or applied to operations, (b) the cash provided by or applied to operations. Net loss Write-off of patent Loss on sale of equipment Decrease in deferred income tax Depreciation Decrease in bank loans payable Decrease in marketable securities Gain on sale of marketable securities Loss from earthquake damage plant Decrease in inventories (net) Loss o n inventory decline to market Increase in interest receivable Decrease in prepaid expenses Share in net income of subsidiary P 76,000 19,000 11,000 18,000 6,000 22,000 20,000 12,000 30,000 19,000 8,000 14,000 10,000 16,000

9. From the following information, determine the cash provided by operations: Net income Extraordinary loss from earthquake damage, net of tax of P 15,000 Income tax applicable to extraordinary income Depreciation Repairs and maintenance Increase in accounts receivable Decrease in inventories Increase in accounts payable Increase in income taxes payable (applicable to ordinary income) Cash applied to construction of building P 21,000 35,000 24,000 40,000 40,000 50,000 20,000 35,000 15,000 100,000

10. The income statement of a merchandising business is presented below. Net sales Less Cost of goods sold Gross profit Operating expenses: Salaries Rent Supplies Bad debts expense Miscellaneous Net income Additional information: (1) Accounts receivable increased by P 12,000 during the year. All sales are made on account. (2) The beginning inventory of merchandise was higher by P 5,000 than the ending inventory. (3) Accounts payable decreased by P 8,000. (4) Salaries payable decreased by P 12,000. (5) Rent payable increased by P 4,000 at the end of the year. (6) All other expenses were paid for during the year. Required: Calculate the cash provided by or applied to operations. Show computations of the cash collections on accounts receivable and the cash paid for the various expenses. 11. The condensed income statement of the Sampaguita Manufacturing Co. for the year ended Dec. 31, 19A is shown below. Net sales Cost of goods sold: Direct materials Direct labor Factory Gross profit Operating expenses Operating income Interest income Net income before Income taxes Net income P 1,500,000 P 450,000 300,000 150,000 P P P P

900,000 600,000 450,000 150,000 20,000 170,000 40,000 130,000

Additional information: (1) Accounts receivable decreased by P 30,000. (2) Inventories of raw materials increased by P 25,000. (3) Accounts payable arising from raw materials purchases increased by P 20,000. (4) Accrued payroll decreased by P 15,000. (5) Factory overhead includes depreciation of P 21,000 and amortization of patent of P 13,000. (6) Operating expenses include depreciation of P 17,000, bad debts of P 6,000, and expired insurance of P 3,000.

(7) Interest receivable decreased by P 4,000. (8) Income tax payable increased by P 7,000. Required: Determine the cash provided by operations. Show the cash flow for each item in the income statement. 12. Maritess Corporation uses the allowance method for bad debts. During 19A, Maritess charged P 30,000 to bad debts expense, and wrote off P 25,000 of uncollectible accounts receivable. These transactions resulted in a decrease in working capital of a. P 0 b. P 4,800 c. P 25,000 d. P 30,000 AICPA 13. George Corporation declared a cash dividend of P 10,000 on January 17, 19A. This dividend was payable to stockholders of record on February 10, 19A, and payment was made on March 2, 19A. As a result of this cash dividend, working capital will increase (decrease) on January 17 February 10 a. P0 P0 b. P 10,000 P0 c. P (10,000) P0 d. P (10,000) P 10,000 AICPA 14. The net income for Mountain Corporation was P 4,000,000 for the year ended December 31, 19A. Additional information is as follows: Depreciation on fixed assets P 2,000,000 Provision for doubtful accounts on short term receivables 200,000 Provision for doubtful accounts on long term receivables 300,000 Dividends on preferred stock 400,000 The working capital provided from operations in the statement of changes in financial position for the year ended December 31, 19A should be a. P 4,900,000 b. P 6.000,000 c. P 6,300,000 d. P 6,500,000 AICPA 15. Selected information from Bejar Corporations accounting records and financial statements for 19A is as follows: Working capital provided by operations P 1,500,000 Mortgage payable issued t acquire land

and building Common stock issued to retire preferred stock Proceeds from sale of equipment Cost of office equipment purchased

P 1,800,000 500,000 400,000 200,000

On the statement of changes in financial position for the year ended December 31, 19A, Bejar should disclose total sources of funds in the amount of a. P 1,700,000 b. P 2,400,000 c. P 3,700,000 d. P 4,200,000 AICPA 16. Ace Companys working capital at December 31, 19A was P 5,000,000. The following additional information pertains to Ace for 19B: Working capital provided by operations P 850,000 Capital expenditures 1,500,000 Short term borrowings 500,000 Long term borrowings 1,000,000 Payments on short term borrowings 250,000 Payments on long term borrowings 300,000 Proceeds from issuance of common stock 700,000 Dividends paid on common stock 400,000 How much was Aces working capital at December 31, 19B? a. P 5,350,000 b. P 5,600,000 c. P 5,750,000 d. P 6,000,000 AICPA 17. Rowena Company is preparing a statement of changes in financial position emphasizing cash flows for the year ended December 31, 19B. It has the following account balances: 12/31/19A 12/31/19B Machinery P 250,000 P 320,000 Accumulated depreciation machinery 102,000 120,000 Loss on sale of machinery 4,000 During 19B, Rowena sold for P 26,000 a machine that cost P 40,000, and purchased items of machinery. 1. Depreciation on machinery for 19B was a. P 18,000 b. P 24.000 c. P 28,000 d. P 32,000 2. Machinery purchases for 19B amounted to a. P 34,000

b. P 70,000 c. P 96,000 d. P 110,000 AICPA 18. The following information is available from Susana Companys accounting records for the year ended December 31, 19B: Cash received from customers P 870,000 Rent received 10,000 Cash paid to suppliers and employees 510,000 Taxes paid 110,000 Cash dividends paid 30,000 Net cash flow provided by operations for 19B was a. P 220,000 b. P 230,000 c. P 250,000 d. P 260,000 AICPA PROBLEMS 2.1 Given below are the balance sheets and selected additional information for the Santiago Company. December 31 19C 19D P 27,000 P 49,150 80,000 110,000 132,000 180,000 290,000 459,000 ( 120,000) ( 135,000) 40,000 _ P 449,000 P 663,150

Assets Cash Accounts receivable Inventory Land, buildings, and equipment Allowance for depreciation Patents Total assets Equities Accounts payable Notes payable Accrued expenses Bonds payable Discount on bonds payable Capital stock Additional paid in capital Retained earnings Total equities

P 24,000 15,000

200,000 30,000 180,000 P 449,000

P 19,000 50,000 16,000 100,000 ( 5,850) 250,000 36,000 198,000 _ P 663,150

Additional information: (1) Equipment costing P 60,000 was acquired during the year by exchanging an old equipment which had a trade-in value of P 10,000 and issuing a short term note payable for the balance.

The old equipment had a cost of P 40,000 and accumulated depreciation of P 25,000. (2) Additional equipment costing P 55,000 was purchased during the year for cash. (3) Depreciation on buildings and equipment for the year was P 40,000. (4) Patents were written off against income in 19D. (5) Ten year bonds with a face value of P 100,000 were issued on October 1, 19D at 94. The proceeds of the bond issue were applied to the construction of a new building. (6) The company issued 500 shares of capital stock for cash at P 112 per share. (7) Dividends declared and paid during the year totaled P 56,000. The only other entry in the Retained Earnings account was the transfer of net income. Required: (1) Prepare a statement of changes in financial position on a working capital basis. (2) Prepare a statement of changes in financial position on a cash basis. 2.2 The following data relating to Soriano Company were available on December 31, 19F: December 31 Debits Cash Marketable securities Accounts receivable (net) Merchandise inventory Long term investments Plant and equipment Discount on bonds payable Total Credits Accumulated depreciation Accounts payable Dividends payable Bonds payable Capital stock (P 50 par) Retained earnings Total Additional data: (1) Net Loss for the year 19F amounted to P 30,000. (2) The company issued 20,000 shares of common stock at par. The proceeds were used to retire the bonds at no gain or loss. (3) Long term investments costing P 100,000 were acquired. 19E 19F

In addition, investments costing P 150,000 were sold at P 180,000. (4) The depreciation for the year amounted to P 70,000 (5) Dividends of P 20,000 were declared during the year. Required: (1) Prepare a funds statement using the working capital concept of funds, (2) Prepare a funds statement using the cash concept of funds. 2.3 The working capital of Bartoolome Co. increased by P 20,000 during the year. Management desires to know what caused the increase in working capital. The following information with respect to nonworking capital accounts of the company is provided: December 31 19B 19C Noncurrent Equities: Long-term debts Deferred income tax Capital stock (P 100 par) Paid-in-capital Retained earnings Noncurrent assets: Investments Plant and Equipment (net) Intangibles assets P 80,000 46,000 205,000 115,000 105,000 P 130,000 61,000 305,000 165,000 140,000

P 125,000 345,000 75,000

P 150,000 550,000 70,000

Additional information: (1) The company issued 1,000 shares of common stock in exchange for land and building appraised at P 150,000. The market price of the stock was P 150 per share. (2) Equipment was purchased for P 75,000 by paying P 25,000 in cash and issuing a long term note of P 50,000 for the balance. (3) Cash dividends of P 50,000 were declared during the year, payable the following year. (4) Additional shares of stock of a subsidiary were acquired during the year. (5) Noncash expenses incurred during the year were: depreciation, P 15,000; amortization of intangibles, P 5,000

Required: Account for the increase in working capital by preparing a statement of changes in financial position.

2.4 The following changes in the balance sheet accounts were derived from the records of the Donato Co.: derived from the records of the Donato Co.: Changes during the year Current assets Investments Plant and equipment Intangibles Current liabilities Long term assets Capital stock Donated capital Retained earnings Debit P 55,000 21,000 153,000 P 30,000 15,000 100,000 90,000 P 259,000 Credit

8,000 46,000

P 259,000 Additional information:

(1) During the year, a correction of a depreciation overstatement in a prior period was made. The entry to correct the error was Accumulated depreciation Retained earnings Income tax payable P 20,000 P 14,000 6,000

(2) Land with an appraised value of P 100,000 was donated to the company by stockholders. (3) An extraordinary repair of P 45,000 was made on equipment. The repairs cost was charged to Accumulated depreciation. (4) Long term debt of P 30,000 plus interest of P 3,000 was paid during the year. (5) No purchases, write offs, or sales of intangibles occurred during the year. (6) The company made an additional investment of P 30,000 in the stock of a 50% - owned subsidiary. The subsidiary reported a net loss of P 18,000 during the year. (7) Retained earnings of P 15,000 were transferred to Capital Stock as a result of a stock dividend. The transfer of net income to Retained Earnings accounted for the remaining change in the balance of the Retained Earnings. The ne income included depreciation expense of P 12,000.

Required: Prepare a statement of changes in financial position applying the working capital concept.

2.5 At December 31, year 5, the following data for the Carlos Company were available: December 31 Cash Accounts receivable Inventory Land Building net Equipment net Patents Year 4 P 34,025 13,000 32,000 140,000 432,000 112,000 58,000_ P 821,150 Year 5 P 95,810 41,375 57,180 130,000 414,000 100,000 80,625_ P 919,390

Accrued expenses Accounts payable Bonds payable Premium on bonds payable Common stock (P 25 par) Paid in capital Retained earnings Treasury stock, at cost

P 6,250 17,500 80,000 2,400 312,500 177,500 248,000 ( 23,000)_ P 821,150

P 7,300 15,000 60,000 1,620 400,500 196,270 247,900 ( 9,200) P 919,390

Additional data: (1) The net income of the company for the current year was P 42,500, which included an extraordinary gain from the condemnation of land of P 24,000 (net of tax of P 10,500). The land had a carrying value of P 50,000. (2) A patent was acquired during the year at a cost of P 25,000. (3) Bonds payable with a face value of P 20,000 was converted into common stock on July 1. Each P 1,000 bond is convertible into 30 shares of common stock. The bond carrying value on the date of conversion was P 25, 570 (face value, P 20,000 plus bond premium, P 570). No gain or loss was recognized on the bond conversion. (4) Equipment with a book value of P 3,600 was sold for P 2,400 resulting in a loss of P 1,200. (5) On June 30, the company issued 1,500 shares of common stock in exchange for land appraised at P 40000. (6) Depreciation and amortization for the year were as follows: Depreciation P 26,000 Amortization of bond premium 210 Amortization of patent 2,500 (7) Treasury stock with a cost of P 13,800 was sold for PO 17,400. (8) On December 31, the company declared a 10% stock dividend on shares outstanding as of December 31.

There were 14,200 shares outstanding on this date. The market price per share of common stock on December 31 was P 30,000. Required: Prepare a statement of changes in financial position adopting a working capital concept. 2.6 Comparative balance sheets of the United Company for 19A and 19B are presented below. December 31 19A 19B

Assets Current assets Investments Land Buildings Accumulated depreciation building Equipment Accumulated depreciation equipment Goodwill Total assets Equities Current liabilities Bonds payable Discount on bonds payable Preferred stock (P 25 par) Common stock (P 50 par) Capital in excess of par common Retained earnings Appraisal capital Treasury stock, at cost (20,000 shares) Total equities

Additional information: (1) Investments of P 150,000 were sold at P 135,000 (2) The land was appraised and increased to its appraised value in 19B. (3) An old building with a cost of P 400,000 and accumulated depreciation of P 320,000 was demolished in 19B. A new building was constructed on the site of the old building. Salvaged materials from the old building were sold for P 30,000. (4) Equipment with a cost of P 100,000 and a book value of P 60,000 was traded in for a new equipment costing P 450,000. The old equipment had a fair market value of P 30,000. (5) A fully depreciated equipment wit ha cost of P 50,000 was written off. (6) Goodwill is being amortized in the books. (7) The company issued new bonds wit h a total face value of P 1,000,000 at 96. (8) Preferred shares totaling to 20,000 shares were purchased in the market at P 30 and retired.

(9) The company reissued all the treasury shares at P 65 per share. (10) The net income for the year was P 700,000. Dividends of P 200,000 were paid during the year. Required: Prepare a statement of changes in financial position applying the working capital concept of funds. 2.7 The balance sheets of Sarmiento Department Store, a sole proprietorship, are given below. Assets Cash Accounts receivable Merchandise inventory Supplies Furniture and fixtures net Total assets Liabilities and capital Accounts payable Accrued expenses Notes payable bank Sarmiento, capital Total liabilities and capital The following additional information is available: (1) The net income of the store during the year amounted to P 16,500. (2) The business borrowed from the bank P 20,000 and issued a promissory note due in one year. (3) Store fixtures costing P 24,000 were purchased during the year. (4) V. Sarmiento, the owner, made an additional investment of P 25,000 on May 1, 19B. He also made withdrawals of P 500 per month during the year. Required: Prepare a statement of changes in financial position applying (a) the working capital concept, and (b) the cash concept. 2.8 Data related to the balance sheets of the Roderick Company for two years are presented below. Assets Cash Marketable securities Accounts receivable (net) Inventories Investments Plant and equipment (net) Patents Discount on bonds payable Total assets December 31 19A 19B December 31 19A 19B

Equities Accounts payable Income taxes payable Bonds payable Preferred stock (P100 par) Common Stock (P 50 par) Additional paid in capital Retained earnings Total equities The income statement of the company for 19B shows the following: Income before income tax and extraordinary item Income tax expense Income before extraordinary item Extraordinary item loss on retirement of bonds (net of tax of P 1,000) Net income Additional information: (1) During the year, long term investments costing P 20,000 were sold for P 40,000. (2) Equipment costing P 30,000 was sold for P 25,000. The accumulated depreciation on the equipment was P 9,400. Depreciation of P 15,000 was recorded during the year. The purchase of equipment accounted for the remaining change in the Plant and Equipment account. (3) The bonds payable were issued on January 1,19A and will mature at the end of ten years. The company purchased P 10,000 face value of bonds in the market are 102 and cancelled the bonds. (4) The preferred stock is convertible into common stock at the rate of one share of common for every share of preferred. During the year, 200 preferred shares were converted into common shares. (5) The company sold 1,000 shares of common stock during the year at P 60 per share. (6) Dividends of P 12,000 were declared and paid during the year.

Required: (1) Prepare a statement of changes in financial position applying the working capital concept. (2) Prepare a statement of changes in financial position applying the cash concept.

2.9 The Perez Co.s balance sheets at the end of December 31, 19A and 19B are given on the following page. You are requested to prepare the statement of changes in financial position applying the cash concept of funds for inclusion in the companys annual report to stockholders.

Assets 19A Cash Marketable securities Allowance for decline in value of marketable securities Accounts receivable net Inventories Investment in Tuason, Inc. Land Buildings net Equipment net Total assets Liabilities Notes payable trade Income taxes payable Dividends payable Bonds payable Premium on bonds payable Deferred income taxes Total liabilities Stockholders Equities Common stock (P 100 par) Paid in capital Retained earnings, appropriated for treasury stock Retained earnings Treasury stock, at cost Total stockholders equity Total liabilities and stockholders equity

December 31 19B

Income statement data for the year ended December 31, 19B showed the following summary of operations: Income before income taxes Income taxes: Current Deferred Ne t income You determine the following additional information: (1) Marketable securities costing P 20,000 were sold for P 14,000. (2)The company has a 40% interest in the stock of Tuason Co., a subsidiary. During the year, Tuason Co. reported a net income of P 50,000 and paid total cash dividends of P 17,500. (3) The company issued 500 shares of common stock and paid.

Additional cash of P 40,000 in exchange for land with a fair market value of P 100,000. (4) The premium on bonds payable is being amortized at the rate of P 1,500 per year. (5) The increase in the deferred income tax resulted from the use of accelerated depreciation method for tax purposes and straight line method for book purposes. (6) Depreciation recorded for the year was P 45,000 (building, P 25,000; equipment, P 20,000). (7) Treasury stock was acquired during the year at a cost of P 10,000. The retained earnings appropriated for treasury stock was correspondingly increased. (8) An addition to the building was made at a rest of P 50,000. (9) No dividends were declared during the year. Required: (1) Prepare a statement of changes in financial position applying the working capital concept of funds. (2) Prepare a statement of changes in financial position applying the cash concept of funds. 2.10 The following financial statements of the Nenceslao Co. for 19A and 19B are available in preparing the statement of changes in financial position for the year ended December 31, 19B using the cash concept: Balance Sheets December 31 19A 19B Assets: Current assets: Cash Accounts receivable net Merchandise inventory Prepaid expenses Total current assets Long term investments Property, plant, and equipment Accumulated depreciation Total assets Equities: Current liabilities: Accounts payable Interest payable Accrued expenses Income taxes payable Dividends payable Total current liabilities Long term notes payable Total liabilities

Stockholders Equity: Common stock Additional paid in capital Retained earnings Total stockholders equity Total equities

Income Statements Year Ended December 31, 19A 19B Sales Cost of goods sold (including depreciation) Gross profit Operating expenses Operating income Interest expense Net income before income taxes Income taxes Net income Required: Compute the following items that will appear in the funds statement: (1) Cash collected from accounts receivable, assuming all sale are on account. (2) Cash payment made on accounts payable, assuming all purchases are made on account. (3) Cash paid for operating expenses. (4) Cash paid for interest expense. (5) Cash paid for income taxes. (6) Cash receipts which were not provided by operations. (7) Cash applied to acquisition of noncurrent assets. (8) Cash paid for dividends. 2.11 The Alcantara Manufacturing Co. has prepared the following statements at the end of the current fiscal year, December 31, 19B: Balance Sheets December 31 Assets 19A 19B Cash Marketable securities Accounts receivable Allowance for doubtful accounts Inventories Prepaid expenses Investment in Acosta Co. Land Buildings (net) Equipment (net) Total assets

Equities Accounts payable Bank loans payable Current maturity of long term debt Dividends payable Income taxes payable Bonds payable Capital stock (P 10 par) Paid in capital Retained earnings Total equities Income and Retained Earnings Statement Year Ended December 31, 19B Revenues and gains: Net sales Gain on sale of marketable securities Equity in net income of Acosta Co. Expenses and losses: Cost of goods sold Selling and administrative expenses Income taxes Interest expense Loss on sale of equipment Net income Retained earnings, Jan. 1, 19B Deduct: Cash dividends declared Stock dividends declared Retained earnings, Dec. 31, 19B Additional data: (1) All sales and purchases are made on account. (2) The cost of goods sold includes depreciation on machinery of P 15,000 and depreciation on building of P 25,000. (3) The selling and administrative expenses include the following expenses: Depreciation building Depreciation equipment Doubtful accounts expense Expired insurance (4) Accounts receivable of P 7,000 was written off during the year against the allowance for doubtful accounts . (5) Equipment with a book value of P 40,000 was sold during the year. (6) An extension to the building was constructed during the year at a cost of P 132,000. (7) On July 1, 19B, the company sold 5,000 shares of common stock at P 11 per share.

(8) On December 31, 19B, the company declared a cash dividend of P 40 per share and a 15% stock dividend. The market price of the stock on December 31, 19B was P 12 per share. (9) The investment in Acosta Co. is accounted for under the equity method. Required: Prepare a statement of changes in financial position applying the cash concept of funds. Show the amounts collected from sales and the payments for various expenses in the income statement. 2.12 Presented below are the balance sheet accounts of Robinson Corporation as of December 31, 19A and 19B. Increase 19B 19A (Decrease) Assets Current Assets: Cash Accounts receivable, net Inventories Total current assets Land Plant and equipment Accumulated depreciation Leased equipment under capital lease Marketable investment securities, at cost Investment in Marzan, Inc., at cost Total assets Liabilities and Stockholders Equity Current liabilities: Current portion of long term debt Accounts payable and accrued expenses Total current liabilities Notes payable, long term Liability under capital lease Bonds payable Unamortized bond premium Deferred income taxes Common stock, par value P 20 Additional paid in capital Retained earnings Total liabilities and Stockholders equity

Additional information: (1) On January 2, 19B, Robinson sold all of its marketable investment securities for P 95,000 cash. (2) On March 10, 19B, Robinson paid a cash dividend of P 30,000 on its common stock. No other dividends were paid or declared during 19B. (3) On April 15, 19B, Robinson issued 2,000 shares of its common stock for land having fair value of P 100,000. (4) On May 25, 19B, Robinson borrowed P 450,000 from an insurance company. The underlying promissory note bears interest at 15% and is payable in three equal annual installments of P 150,000. The first payment is due on May 25, 19C. (5) On June 15, 19B, Robinson purchased equipment for P 392,000 cash. (6) On July 1, 19B, Robinson sold equipment costing P 52,000, with a book value of P 28,000, for P 33,000 cash. (7) On September 1, 19B, Robinson paid a P 20,000 additional tax assessment for 19A due to an error in tax calculation discovered by the Bureau of Internal Revenue. This payment was appropriately recorded by Robinson as a prior period adjustment. (8) On December 31, 19B, Robinson leased quipment from Tualla Company, for a ten year period. Equal payments each year. The first payment was made on December 31, 19B. The present value at December 31, 19B of the ten lease payments is P 158,000. Robinson appropriately recorded in the lease as a capital lease. The P 25,000 lease payment dued on December 31, 19C will consist of P 9,000 principal and P 16,000 interest. (9) Robinsons net income for 19B is P 253,000. (10) Robinson owns a 10 % interest in the voting common stock of Marzan, Inc. which is appropriately accounted for by the cost method. Marzan reported net income of P 120,000 for the year ended December 31, 19B, and paid a common stock dividend of P 55,000 during 19B. Required: Using the working capital approach prepare a statement of changes in financial position of Robinson Corporation for the year ended December 31, 19B. Do not prepare a schedule of changes in working capital. AICPA 2.13 Presented below are the consolidated work paper balances of Ben, Inc., and its subsidiary, Doria Corporation. Net Change Increase (Decrease)

Assets Cash Marketable equity securities, at cost

19B

19C

Allowance to reduce marketable equity securities to market Accounts receivable, net Inventories Land Plant and equipment Accumulated depreciation Goodwill, net Total assets Liabilities and Stockholders Equity Current portion of long term debt Accounts payable and accrued liabilities Note payable, long term Deferred income taxes Minority interest in net assets of subsidiary Common stock, par P 10 Additional paid in capital Retained earnings Treasury stock, at cost Total liabilities and stockholders equity

Additional information: (1) On January 20, 19B, Ben, Inc. issued 10,000 shares of its common stock for land having a fair value of P 215,000. (2) On February 15, 19B, Ben, Inc. reissued all of its treasury stock for P 44,000. (3) On May 15,19B, Ben, inc. paid a cash dividend of P 58,000 on its common stock. (4) On August 8,19B, equipment was purchased for P 127,000 (5) On September 30, 19B, equipment was sold for P 40,000. The equipment cost P 62,000 and had a carrying amount of P 34,000 on the date of sale. (6) On December 15, 19B, Doria Corporation paid a cash dividend of P 50,000 on its common stock. (7) Deferred income taxes represent timing differences relating to the use of accelerated depreciation methods for income tax reporting and the straight line method for financial reporting. (8) Net income for 19B was as follows: Consolidated net income Doria Corporation (9) Ben, Inc. owns 70% its subsidiary, Doria Corporation. There was no change in the ownership interest in Doria Corporation during 19A and 19B. There were no intercompany transactions other than the dividend paid to Ben, Inc. by its subsidiary.

Required: Using the cash concept of financial resources, prepare a consolidated statement of changes in financial position of Ben, Inc. and Subsidiary for the ear ended December 31, 19B. AICPA 2.14 Presented below are the condensed statements of financial position of Public Relations associates as of December 31,, 19B and 19A and the condensed statement of income for the year ended December 31, 19B. Public Relations Associates CONDENSED STATEMENTS OF FINANCIAL POSITION December 31, 19B and 19A Net Change Increase (Decrease)

Assets Cash Accounts receivable, net Investment in Kato, Inc., at equity Property and equipment Accumulated depreciation Excess cost over book value of investment in Kato (net) Total Assets Liabilities and Partners Equity Accounts payable and Accrued expense Mortgage payable Partnerships equity Total liabilities and partners equity

19B

19A

Public Relations Associates CONDENSD STATEMENT OF INCOME For the Year Ended December 31, 19B Fee revenue Operating expenses Operating income Equity in earnings of Kato, Inc. (net of P 2,000 amortization of excess cost over book value) Net income

Additional information: (1) On December 31, 19A, partners capital and profit sharing percentages were as follows: Capital Profit Sharing % Borja Calma (2) On January 1, 19B, the partners admitted Dario to the partnership for a cash payment of P 170,000 to Public Relations Associates. In addition, Dario paid a P 100,000 cash bonus directly to Borja and Calma. This amount was divided P 60,000 to Borja and P 40,000 to Calma. The new profit sharing arrangement is as follows: Borja Calma Dario (3) On July 1, 19B, Public Relations Associates purchased an office computer for P 85,000 which included P 10,000 for sales tax, delivery, and installation. There were no dispositions for property and equipment during 19B. (4) Throughout 19B, Public Relations Associates owned 25% of the common stock of Kato, Inc. During 19B, Kato paid cash dividends totaling P 192,000 and reported net income of P 360,000. Publics 19B amortization of excess cost over book value in Kato was P 2,000. (5) Partners drawings for 19B were as follows: Borja Calma Dario

Required: Using the cash concept of funds, prepare a statement of changes in financial position of Public Relations Associates for the year ended December 31, 19B. AICPA

Chapter 3 FINANCIAL STATEMENT ANALYSIS Analysis, defined The dictionary defines analysis as separating a material or thing into its constituent elements. Financial statement analysis may thus be defined as separating the total information provided by financial statements into its component parts so that the relationship of the arts to each other or to the whole can be determined and evaluated. The first phase in financial statement analysis is establishing logical relationships between items of information found in the same statement or different statements. Once relationships have been established and expressed in the form of formulas or through certain procedures, the next phase is to perform the computations. The last phase is evaluating or interpreting the results of the computations. The evaluation phase consist in determining whether the relationships are favorable or unfavorable and ascertaining the causes of unfavorable results. This constitutes the most important phase in financial statement analysis. In actual practice, logical relationships between items of information found in the financial statements have been established and developed. Thus, there are various techniques and procedures which are available. The financial analyst needs only to choose the techniques and procedures which are appropriate under the circumstances. Only in rare instances may the financial analyst develop his own formulas or adopt procedures which will suit his specific objectives. The various techniques of financial statement analysis are discussed in this chapter. Objectives of Analysis In analyzing financial statements, attention is usually directed to the following questions: 1) Can be the business meet its current debts as they mature? 2) Does the business earn adequate profit in relation to the volume of its sales and the size of its investment? 3) Can the business provide adequate protection to the funds invested by stockholders and long term creditors as well as meet the principal, interest, and dividend requirements on these funds? The first of the above questions relates to the liquidity of the business; the second, to its profitability; and the third, to its stability. Financial statement analysis does not aim to provide answers to problems. It merely aids in evaluating the liquidity, profitability, and stability of a business, which are important to various parties in making conclusions or decisions concerning the business.

Parties Interested in Analysis The analysis of financial statements is of concern to the following users of financial statements: 1) Short term creditors These users undertake analysis of financial statements of a business as a basis for granting short term credit. Their focus is on the liquidity of a business. 2) Long term creditors Long term creditors are interested I the ability of a business to service debt on a long term basis. They are thus interested in the stability of the business as well as in its profitability and liquidity in so far as these affect stability. 3) Investors Investors need to know whether the present and future earnings of a business are adequate and stable before they invest in a business, or decide to continue with their present investments. 4) Managers The managers of a business are interested in those aspects of financial statement analysis which investors and creditors use in evaluating the business since these affect their ability to obtain financing. They are also concerned with financial statement analysis in evaluating internal control, the efficiency of asset utilization, and internal control, the efficiency of asset utilization, and the profitability of investments in various assets. 5) Government agencies Government agencies are interested in financial statement analysis for taxation, regulatory, and statistical purposes. 6) Employees Employees and their unions are concerned wit the stability and the profitability of a business because these affect their compensation, advancement, and security with the company. 7) Others (e.g., stock exchanges, trade associations, students, researchers, and the general public) These users are interested in financial statement analysis for various reasons. Analytical Tools A worker needs tools in order to perform his job properly. The financial analyst uses the following tolls in analyzing financial statements: 1) Absolute peso amounts 2) Percentages 3) Ratios 4) Index numbers, or trend percentages The use of absolute amounts, percentages, and ratios is illustrated below. The amounts being analyzed are assumed to be the net income or loss of a business over a period of two years.

Net income (loss) 19A 19B

Increase (Decrease) Amount Percent Ratio

The peso amounts of change are obtained by subtracting the figures of 19B, from the figures of 19A. The earlier year, 19A, is called the base year. if the difference is positive, the change is an increase. If the difference is negative, the change is a decrease and is indicated by enclosing the decrease in parentheses. Peso amounts of change can be computed regardless of the base amount. The percentage increase or decrease in net income (or loss) is computed by dividing the peso amount of increase or decrease by the amount in the base year. Percentage changes can be calculated only if the base amount is positive. When the base amount is zero or negative, a percentage change is not computed. Percentage changes are relative amounts which indicate t the importance of an increase or decrease relative to the base amount. A large amount off increase, for example, may be seen in better perspective if it is related to the base amount and expressed as a percentage. Ratios are derived by simply dividing each figure for 19B by the corresponding figure for 19A. Ratios are computed only when amounts are related and the two amounts are positive. They are not computed when the base amount is zero or negative. The use of index numbers or trend percentages, are illustrated in the following example: 19A Sales Sales indexes The sale indexes are computed as follows: (1) A base year is selected, which, in the above example, is 19A, the earliest year. The base amount is assigned as sales index of 100. (2) The sales indexes for the sales of the subsequent years are calculated by dividing the sales for each year by the sales of the based year. Index numbers are computed when data for several years or periods are available. They indicate the change which occur in an item over a period of time and are useful in discovering trends. In the above example, the sales indices show that the trend for sales is an increasing one. 19B 19C 19D 19E

Horizontal Analysis A comparison of changes in the same items over two or more periods is referred to as horizontal analysis. In horizontal analysis, comparative financial statements are being studied. Comparative financial statements are financial statements for two or more successive periods, which are usually presented side by side. When comparative financial statements are being analyzed, comparisons can be made in various ways, as follows: (1) In the case of comparative statements prepared for two years, comparisons are made using the financial statements of the earlier year as the bases for comparison. An illustration of this procedure is shown below. Santiago Company Comparative Income Statement For the Years Ended December 31, 19A and 19B

(c) In the case of monthly financial statements, the financial statements of the current month are compared with the financial statements of the same month of the preceding year. For example, the sales of December, 19B is compared with the sales of December 19A. (d) In the case of cumulative statements, the financial statements for the period to date are compared with the corresponding period of the preceding year. For example, the sales of the 4th quarter of 19B is compared with the sales of the 4th quarter of 19A. In the case of (c) and (d) above, while it is possible to compare the sales of the current month or quarter with the sales of the immediately preceding month or quarter, the comparisons may be distorted by seasonal fluctuations in business activity. Comparing the results of the current month or the year to date with the corresponding period of the preceding year eliminate this distortion. Vertical Analysis The analysis of the relationship of an item to the total of the items in the same statement is referred to as vertical analysis. In vertical analysis, a single financial statement is being studied. The relationship of an individual item to the total item to the total item in the financial statement is called a component percentage. Component percentages indicate the relative size of each item to the total item in a financial statement. Comparative statements may also be analyzed vertically by converting the amounts in the balance sheets or income statements into component percentages. In the case of the balance sheet, the amounts can be converted into component percentages in tow steps, as follows: (1) Asset items are converted into component percentages by assigning to the amount of total assets, which is the base amount, a percentage of 100. The amount of each asset is then divided by the total assets to obtain the component percentage for each item. (2) Liability and stockholders equity item are converted into component percentages by assigning to the total liabilities and stockholders equity a percentage of 100. Each liability or capital item is then divided by the total liabilities and stockholders equity to derive the component percentage for that item. The computation of component percentages for a balance sheet is presented on the following page. Income statements items are converted into component percentages by expressing net sales as 100 percent and then dividing each item in the income statement by net sales to percentages for a comparative income statement is likewise shown on the following page.

Santiago Company Comparative Balance Sheet December 31

Common size Statements Financial statements which show only component percentages and no peso amounts are called common size financial statements. A common size income statement using the above example is presented below. Santiago Company Common size Income Statements For the Years Ended December 31, 19A and 19B 19B Net sales Cost of goods sold Gross profit Operating expenses: Selling expenses General expenses Total expenses Operating income Interest expense Net income

19A

Other Bases of Comparison The past performance or experience of a business constitutes the primary basis for comparing current performance. The performance or condition of a particular company can also be compared with the performance or condition of the entire industry to which the particular company belongs or with a major competitor in the same industry. By comparing the performance of the company with those of the industry or a competitor, the business will know how well it is performing in relation to other businesses or the industry as a whole. The comparison may reveal inadequacies or weaknesses which may not be apparent by a comparison that is made only within the business. An example of this procedure is shown in the income statements below, which are presented in common size form. XYZ Co. Net Sales Cost of goods sold Gross profit Operating expenses Net income Ratio Analysis A ratio expresses the relationship between two related amounts. It is obtained by dividing one amount by another amount. The related amounts may be taken from a single statement, such as income statement, or from two different statements, such as income statement and balance sheet. Ratios may be classified into liquidity, profitability, and solvency ratios. ABC Co.

To illustrate the use of ratios, the financial statements of a manufacturing firm are presented on the following pages. Soliman Company Comparative Balance Sheet December 31 Assets Current Assets Cash Marketable securities Accounts receivable Inventories: Raw materials Work in process Finished goods Prepaid expenses Total current assets Long-tern investments Plant assets: Land Building Equipment Total Accumulated depreciation Net Total assets Liabilities Current liabilities Accounts payable Notes payable Accrued expenses Total current liabilities Long-tern debt-bonds Total liabilities Stockholders Equity 7% Preferred Stock (P100 par) Common stock (P10 par) Retained earnings Total stockholders equity Total liabilities and stockholders equity 19C P 24,000 30,000 20,000 40,000 50,000 60,000 14,000 P 238,000 100,000 P 250,000 450,000 280,000 980,000 230,000 750,000 P 1,088,000 19B P 14,000 26,000 35,000 19A P 12,000 20,000 25,000

Soliman Company Comparative Income Statement For the Years Ended December 31 19C Net sales Cost of goods sold: Direct materials: Materials inventory, Jan. 1 Purchases Materials available for use Materials inventory, Dec. 31 Direct materials used Direct labor Factory overhead Total manufacturing costs Work in process inventory, Jan. 1 Work in process inventory, Dec. 31 Cost of goods manufactured Finished goods inventory, Jan. 1 Total goods available for sale Finished goods inventory, Dec. 31 Cots of goods sold Gross profit Operating expenses: Selling expense Administrative expense Total operating expense Net operating income Non operating items: Interest expense Interest income Net financial expense Net income before taxes Income taxes Net income

19B

19C

Soliman Company Comparative Retained Earnings Statement For the Years Ended December 31 Retained Earnings, Jan. 1 Net income during the year, per income statement Total Dividends: Preferred Common Total Retained Earnings, Dec. 31

Ratios Measuring Liquidity Liquidity, or short term solvency, is the ability of a business to meet its current debts as they fall due. It may also be viewed as the ability of a business to convert assets into cash for the payment of its liabilities. The ease with which various assets can be converted into cash varies. Receivables, for example, are more liquid than inventories because they are more readily convertible into cash. In other words, the length of time it takes receivables to be converted into cash is shorter than that of inventories. Inventories, in turn, are more liquid than plan and equipment. Cash, of course, is the most liquid of all assets. In assessing the liquidity of a business, the focus is on the current position of a business, that is, the current assets and current liabilities. The current assets are the focus of liquidity analysis as these are the assts which are normally used to pay current liabilities. More specifically, the liquidity of a business is measured by the following ratios, 1) the current ratio, 2) the distribution of current assets, 3) the turnover of current assets, and 4) the number of das to turn over current assets. Current ratio The current ratio, sometimes called the working capital ratio or bankers ratio, is the rough measure of the companys ability to meet its current obligations as they mature. It expresses the relationship between current asses and current liabilities and is calculated as follows: Current assets Current ratio = Current liabilities ` The current ratios for the Soliman Co. are computed below. 19B Current assets Current liabilities Current ratio A current ratio of 1.68 means that for every peso of current liabilities, there are P 1.68 of current assets. The larger the current assets relative to the current liabilities, the higher is the current ratio. A company with a higher current ratio is tin a more comfortable current position than one that has a smaller current ratio. On the other hand , a ratio that is too high may indicate that a business has more working capital than it needs. A ratio of at leas 2:1 has ordinarily been regarded as favorable. This rule of thumb, however, is arbitrary and should not be applied to all situations indiscriminately. Other factors or measures should be considered before conclusions can 19C

be made regarding a companys liquidity. In addition to the current ratio, the following factor affecting liquidity should be considered: 1) The nature of the companys business. 2) The composition and quality of the current assets. 3) The movement of current assets. 4) The length of time required to convert current assets into cash. The nature of a companys business need to be taken into account in assessing its liquidity, Some companies require a large amount of working capital and a longer period of time to convert their current assets into cash, thus requiring a higher current ratio. Other companies do not carry large inventories and conduct business mostly on a cash basis and thus are not expected to maintain a high current ratio. A current ratio of less than 2:1 may not be inadequate for these companies. The composition and quality of current assets need also to be considered. For example, a business with a larger proportion of cash in its current assts is in a better position to pay its current debts than a company which has a large potion of its current assets invested in inventories. A company with large past due accounts in its receivables is also in a less desirable position than a company whose accounts are all current. The composition of current assets can be determined by calculating the percentage of each current asset to the total current assets, and by the quick ratio. The quality of current assets may also b analyzed, for example, by aging the receivables or by determining the salability of inventories. Some inventories may be obsolete, damaged, or deteriorated. The quality of current assets may also be analyzed by calculating the turnover of current assets and the number of days to turnover or convert assets into cash. A turnover indicates the number of times than an asset or a group of assets is disposed of or converted into another asset (like cash) or group of assets. It is a measure of the efficiency with which assets are utilized. As a general rule, assuming all other factors to be constant, higher turnover is more favorable than a lower turnover. Turnover rates can be converted or translated into the number of days to turnover or convert assts into cash. Distribution of current assets The proportion of each current asset to the total current assets of the Soliman Company is shown on the following page Quick ratio The quick ratio, or acid test ratio, is a more rigid test of the liquidity of a business. It measures the ability of a business to meet immediate demands upon its current asset for the payment of current liabilities. The quick ratio is computed as follows:

Quick ratio =

Quick assets Current liabilities

Percentage Distribution of Current Assets Current assets: Cash Marketable securities Accounts receivable Raw materials inventory Work in process inventory Finished goods inventory Prepaid expenses Total current assets 19B Amount % 19C Amount &

The quick assets include cash, marketable securities, and receivables. Inventories and prepayments are excluded in the ratio as these assets require a considerable time for their conversion into cash. They are less liquid than the quick assets. The quick ratio for the Soliman Co. are computed as follows: 19B 19C Quick assets: Cash Marketable securities Accounts receivable Total quick assets Total current liabilities Quick ratio Accounts Receivable Turnover The accounts receivable turnover indicated the number of times that the average accounts receivable is collected or converted into cash during the year. It measures the speed with which receivables are collected. The accounts receivable is computed as follows: Net credit sales Average accounts receivable

Accounts receivable turnover =

The net credit sale is used in the ratio as accounts receivable arise only from sales. However, total sales would be used if cash sales are insignificant or constitute a relatively constant percentage of sales. The average receivable is used in computing the ratio. Ideally, the average of the receivables at the end of every month should be used. However, since the receivables at year end are more readily obtained, the average of the beginning and year end balances are usually used. The accounts receivable in the ratio refers to gross receivables. Accounts which are doubtful of collection should not be excluded. However, of he only available data re the net receivables, then they would be used. The calculation of the accounts receivable turnovers for the Soliman Co. are presented on the following page.

19B Net sales Average accounts receivable Accounts receivable turnover

19C

A low turnover rate may indicate overextension of credit, inability of customers to pay, or a poor collection effort. On the other hand ,a high rate of turnover may indicate a strict credit extension policy or reluctance to extend credit, which may result to a loss of additional profit. Number of days sales in receivables The number of days in sales in receivables represents the average number of days required to collect the receivables. It is computed directly from the following formula: Average accounts receivables Number of days sales in receivables = Net credit sales

X Days in year

The number of days in the formula may refer to the number of days in the calendar year consisting of 365 or 360 days or to the number of operating days in the year, like 300 days. The number of days sales in receivable for the Soliman Co. are as follows: 19B Average accounts receivable Net sales Days in year (assumed) Number of days sales in receivables Accounts receivables turnover can be converted into the number days sales in receivables. This is accomplished by dividing the number of days in the year the accounts receivable turnover. For the Soliman Co., the calculations are: 19B = 360 days 30 = 12 days 19C = 360 days 43.64 = 8 days 19C

Sometimes, it is desirable to determine the number of days in ending receivables. In this case, the receivables at the end of the year are used in the formula instead of the average accounts receivable. For the Soliman Co., the number of days sales in ending receivables are: 19B Accounts receivable, year end Net sales Days in year (assumed) Number of days sales in ending receivables 19C

The number of days sales in receivables is an indicator of the efficiency of the business in collecting receivables. If the business is prompt in collecting its receivables, the number days sales in receivables will be small; if the business is slow, the number of days sales in receivables will be high. In evaluating the ratio, however, the type of business must be considered as different businesses have varying credit terms. A comparison of the ratio with the credit terns will indicate if the business is slow, moderate, or fast in collecting receivables. The number of days ales in receivables also gives an indication of the quality of the receivables. If the collection period is high relative to the credit period, some of the receivables are probably not being collected within the credit period extended o customers. These receivables are past due and are of lesser quality than receivables which are more current. Inventory turnovers In a merchandising firm, an inventory turnover can be computed for merchandise inventory. We have therefore a merchandise inventory turnover. In a manufacturing firm, there are three types of inventories, namely, finished goods, work in process, and raw materials. Consequently, three inventory turnovers can be computed: Finished goods turnover, work in process turnover, and raw materials turnover. Finished goods turnover The finished goods inventory turnover indicates the number of times that the average finished goods inventory is sold during the year. Alternatively, it is the number of times that the average finished goods inventory is converted into receivables during the year. The finished goods inventory turnover is calculated as follows:

Finished goods inventory = turnover

Cost of goods sold Average finished goods inventory

The finished goods inventory turnovers for the Soliman Co. are calculated as follows: 19B Cost of goods sold Average finished goods inventory Finished goods turnover The average finished goods inventory is the average of the beginning and ending finished goods inventories. If monthly inventory balances are available, these would preferable be used in computing the average. A low rate of turnover may suggest overstocking, slow moving items, obsolete inventories, or overestimating of sales. A high turnover may suggest stocking of small inventories fast moving items, or underestimation of sales. A high turnover rate 19C

due to maintaining a small inventory may not be desirable as it may mean large ordering costs, loss of quantity discounts, and loss of sales to customers. Generally, however, a higher inventory turnover is preferable to lower turnover, assuming that the profit per turnover is maintained. If a higher turnover is accompanied by a smaller profit per turnover, a drop in total profit may result. Number of days sales in inventories The number of days sales in inventories is the average number of days required to dispose or sell the average inventory. In other words, it is the average number of days needed to convert the finished goods inventory to accounts receivable. It is computed as follows: Number of days sales in = Inventories Average finished goods inventory Cost of goods sold

Days in year

The number of days sales in inventories for the Soiman Co. are: 19B Average finished goods inventory Cost of goods sold Days in year Number of days sales in inventories 19C

The number of days sales in inventories can also be computed by dividing the days in the year by the finished goods inventory turnover, as shown below. 19B = 360 days 9.04 = 40 days 19C= 360 days 8.98 = 40 days

If the inventory position at the end of the year is to be analyzed, the number of days sales in ending inventories can be computed by substituting the ending inventory balance for the average finished goods inventory in the formula. For the Soliman Co., the computations are: Finished goods inventory, year end Cost of goods sold Days in year Number of days sales in ending inventories Work in process inventory turnover The work in process inventory turnover is calculated by dividing the cost of goods manufactured by the average work in process inventory. The turnover indicates the average number of times that the average work in process inventory is transformed into finished goods. The number of days to convert work in process to finished goods can be derived by dividing the days in the year by the work in process inventory turnover.

The work in process inventory turnovers and the conversion periods for work in process are computed below for the Soliman Co. 19B Cost of goods manufactured Average work in process inventory Work in process turnover Days to turnover work in process Raw materials turnover The raw materials turnover is computed by dividing the cost of materials used by the average raw materials inventory. The number of days to convert raw materials into work in process, or alternatively, the number of days supply in raw materials, is obtained by dividing the days in the year by the raw materials inventory turnover. The rates are calculated for the Soliman Co. below. 19B 19C Cost of raw materials used Average raw materials inventory Raw materials turnover Days to turnover raw materials The Operating Cycle The operating cycle is the average period of time required for a business to convert cash to inventories, inventories to receivables, and receivables back into cash. The cycle covers the series of activities from purchasing materials, processing inventories of raw materials to finished goods, selling finished goods inventory, and collecting receivables. The length of the operating varies from one business to another business. It may range from a short period of time, like a few months, to several years. The operating cycle of a business can be estimated by adding the conversion period for the various classes of inventories and the number of days sales in receivables. This is illustrated below for the Soliman Co. using the 19C figures. Days Days to convert raw materials to work in process Days to convert work in process to finished goods Number of days sales in inventories Number of days sales in receivables Operating cycle Accounts payable turnover The accounts payable turnover is calculated by dividing the amount of credit purchases by the average accounts payable. The number of days purchases in payables is computed by dividing the days in the year by the accounts payable turnover. 19C

Calculations of the accounts payable turnovers and number of days purchases in payables for the Soliman Co. are made below. 19B 19C Purchases Average accounts payable Accounts payable turnover Number of days purchases I payables Current asset turnover The current asset turnover is a turnover of a group of assets the current assets. It indicates the number of times that the average current assets have been replenished during the year in the process of generating sales or meeting operating costs. The current asset turnover can be computed in two alternative ways, as follows: Net Sales Current asset turnover = Average current assets or Cost of goods sold operating Current asset turnover = expense (excluding depreciation) Average current assets The second formula differs fro the first in that it excluded profit, non operating items, and depreciation in the numerator. Depreciation is excluded as it is an operating expense not related to current assets. The current asset turnovers for the Soliman Co. using the first formula are given below. 19B Net sales Average current assets Current asset turnover Using the second formula, the calculations for the Soliman Co. are: 19B Cost of goods sold Operating expenses Total Less depreciation Cost of goods sold plus operating expenses (excluding depreciation) Average current assets Current asset turnover Number of Days to Cover Working Capital Deficit The focus in analyzing liquidity is the working capital position, the current assets and current liabilities. Current assets should be sufficient to pay current debts and meet 19C 19C

operating costs. The relationship between current assets and current liabilities may be expressed in what is called the working capital, or more specifically, net working capital. The working capital is simply current assets minus current liabilities. The working capital for the Soliman Co. for 19B and 19C are computed below. 19B 19C Current assets, year end Less current liabilities, year end Working capital The working capital for the Soliman Co. for both years are positive. In some cases, the difference between current assets and current liabilities become negative, the current liabilities being greater than the current assets. In these cases, a working capital deficit exists. The number of days that the working capital deficit can be recovered from funds provided by operations may be determined from the following formula: Number of days to cover = Working capital Deficit Working capital deficit Working capital Provided by Operations

X Operating Days in Year

Ratios Measuring Profitability Profitability is the ability of a business to generate earnings. Profitability is determined by the amount as well as the regularity and trend of earnings. The amount of earnings must be adequate in relation to the volume of sales and the amount of investment. Ratios showing in relation to sales include the following: 1) The rate of return on sales, 2) The gross profit rate, and 3) The rate of operating profit. Since operating expenses affect profit, profitability can also be measured by relating expenses to sales. Ratios relating expenses to sales are 1) The operating ratio, and 2) Operating expense ratio. The ratios showing profitability in relation to investment are: 1) The rate of return on total assets, 2) The rate of return on total stockholders equity, and 3) The rate of return on common stockholders equity. The regularity and trend of earnings can be analyzed by looking at the earnings history of a business. A stable record of earnings would be preferable o a record of erratic or fluctuating earnings. On the other hand, an increasing trend of earnings would be preferred over a stable pattern of earnings. Investors and long term creditors pay particular attention to the earnings history of a business to predict future earnings,

the market price of the stock of the company, and the ability of the business to meet principal, interest, and dividend payments in the long run. Rate of return on sales The rate of return on sales, also called profit margin or net income percentage, is obtained by dividing net income after taxes by net sales. The rate is a measure of overall profitability as all expenses have been deducted from sales in arriving at the net income. The rate of return on sales for the Soliman Co. are determined as follows: 19B 19C Net income after taxes Net sales Rate of return on sales A rate of return on sales of 26% means that for every peso of sales, the business earns a profit of 26 centavos. Gross Profit rate The gross profit rate, or gross margin percentage, is obtained by dividing the gross profit by net sales. It measures the adequacy of the mark-up on products sold. The gross profit rate must be adequate to cover operating expenses well as other non operating expenses. The gross profit rates for the Soliman Co. are calculated below. 19B 19C Gross profit Net sales Gross profit rate Rate of operating profit The rate of operating profit is obtained by dividing the operating income by the net sales. Operating income excludes such items as interest, rents, dividends, extraordinary items, and income taxes. The rates of operating profit for the Soliman Co. are: 19B 19C Net operating income Net sales Rate of operating profit Expense Ratios The operating ratio and operating expense ratio are given by the following formulas:

Operating ratio = Cost of goods sold Operating expenses Net Sales Operating expense ratio = Operating expenses Net Sales

The operating ratio and operating expense ratio are measures of efficiency. They indicate the ability of the business to control operating costs. An increase in either of these ratios means that cost of goods sold or operating, or both, are increasing relative to sales. The operating ratios and operating expense ratios for the Soliman Co. are computed below. 19B Cost of goods sold Operating expenses Cost of goods sold plus operating expenses Net sales Operating ratio Operating expense ratio Rate of return on total assets The rate of return on total assets measures the ability of the business to earn a return on all the financial resources provided by stockholders and creditors. It is computed by the formula: Rate of return on = total assets Net income Average total assets 19C

The net income in the numerator refers to net income from continuing operations after taxes. It excludes extraordinary items, disposals of segments of business, and the cumulative effect of changes in accounting principles. The average total asset is the average of total assets available. The rates earned on total assets for the Soliman Co. are computed as follows: 19B Net income Average total assets Rate of return on total assets The rate of return on total assets is a measure of overall performance of a business. Its significance as a measure of overall performance can be better appreciated by analyzing its component ratios. The rate of return on total assets is the product of two ratios: the rate of return on sales and the assets turnover rate, as shown below. Rate of return on = Net income X total assets Net sales Net Sales Average total assets 19C

The first ratio on the right hand side of the equation is the rate of return on sales; the second ratio is the assets turnover rate. The rate of return on sales, previously discussed, measures the overall profitability f the business. On the other hand, the assets turnover rate measures the utilization of total assets and indicates the contribution made by total assets to sales.

The expanded formula shows that a given rate of return results from a combination of the rate of return on sales and the assets turnover rate. For example, a rate of return on total assets of 20% may be the result of a rate of return on sales of 4% and an asset turnover rate of 5 times. Various combinations of the rates of return on sales and the assets turnover rate can yield a given rate of return. The table below, for example, shows various combinations of the two rates that can yield a rate of 20% on total assets. Rate of return on sale 4% 5% 8% 10% 20% Asset turnover rate 5.0 4.0 2.5 2.0 1.0 Rate of return on total assets 20% 20% 20% 20% 20%

The relationship between the rate of return on sales and the assets turnover rate shows that a low rate of return on sales can be offset by a high assets turnover rate, or that a low assets turnover rate can be offset by a high rate of return on sales. If a business aims to maximize its rate of return on sales, it is evident that this can be achieved by improving the rate of return on sales or the asset turnover rate, or both. It is usually desirable to measure only the operating performance of a business. In this case, the operating rate of return is the appropriate ratio, which is given by the following formula.

Operating income refers to the income before interest and taxes. It excludes non operating items such as interests and rent, extraordinary items, and income taxes. Operating assets are the total assets available minus idle plant assets, investments, and other assets not related to operating income. The operating rate of return on operating assets for the Soliman Co. are given below. 19B Operating income Average operating assets (total assets less investments) Operating rate of return Rate of return on total stockholders equity This rate measures the return on the resources provided by owners of the business, whether by preferred or common stockholders. It is obtained by dividing net income by the average total stockholders equity. 19C

The rates of return on total stockholders equity for the Soliman Co. are developed as follows: 19B Net income Average total stockholders equity Rate earned on total stockholders equity Rate of return on common stockholders equity The rate earned on the resources provided by the common stockholders, or residual owners, can also be computed as follows: Rate of return on common = stockholders equity Net income preferred dividends Average common stockholders equity 19C

For the Soliman Co., the rates are computed as follows: 19B Net income Less preferred dividends Net income applicable to common Average common stockholders equity Rate earned on common stockholders equity Financial Leverage Financial leverage, or trading on the equity, is utilizing the existence of a given amount of equity capital to borrow funds. A business resorts to the use of debt because debt may be less expensive than equity capital. Debt may be less expensive for two reasons: first, the interest on borrowed funds is tax deductible; second, the interest cost on borrowed funds is fixed. If the rate earned on borrowed funds exceeds the interest cost on the debt, the excess return accrues to the benefit of the stockholders. The effect is to increase the rate of return on stockholders equity. To illustrate the effects of financial leverage, consider the following example: A company with an outstanding capital stock of P 600,000 is in need of additional funds in the amount of P 400,000. Two methods of financing are being considered: to issue 4,000 additional shares of stock at P 100 per share or to 5% bonds with a total face value of P 400,000. The company expects to earn a return of 10% before interest and taxes on its assets. The income tax rate is 30%. The resulting capital structures under the two alternatives are presented below. Issue bonds Issue stock 5% Bonds payable P 400,000 P Common stock 600,000 1,000,000 Total equity (assets) P1,000,000 P1,000,000 The ratios of return on total assets and on common stockholders equity under the two alternatives are computed on the following page. 19C

Operating income (10% of P1, 000, 000) Less interest expense (5% of P400, 000) Net income before income taxes Less income taxes (30%) Net income Rate of return on total assets Rate of return on common stockholders equity

Issue Bonds P100, 000 20, 000 P 80, 000 24, 000 P 56, 000 5.60% 9.33%

Issue Stock P100, 000 - ____ P100, 000 30, 000_ P 70, 000_ 7.00% 7.00%

The rate of return on the common stockholders without bond leverage is 7%, the same rate as the rate of return on total assets. With bond leverage, the rate of return on the rate of return on the common stockholders equity was due to a favourable bond leverage. The company was able to earn a return on borrowed funds that was higher than the interest on the bonds, as shown below. Return on borrowed funds (P400, 000 x 10%) Less income taxes (P40, 000 x 30%) Interest on borrowed funds (40, 000 x 5%) Less income taxes (P20, 000 x 3%) Net advantage to stockholders P20, 000 6, 000 P40, 000 P12, 000 P28, 000 14, 000 P14, 000

Financial leverage can also be unfavourable to the stockholders. Suppose that the company was able to earn only 4% before interest and taxes on its assets. The rates of return on total assets and on common stockholders equity would be: Issue Bonds Issue Stock Operating income P40, 000 P40, 000 Net income before taxes P20, 000 P40, 000 Less income taxes 6, 000 12, 000 Net income P14, 000 P28, 000 Rate return on total assets 1.4% 2.8% Rate on return on common stockholders equity 2.33% 2.8% The rate of return on common stockholders equity is now lower with bond leverage. The leverage was unfavourable because the company was able to earn a return on borrowed funds that was less than the interest on the bonds, as computed below. Return on borrowed funds (P400, 000 x 4%) Less income taxes (P16, 000 x 30%) Interest on borrowed funds (P400, 000 x 5%) P20, 000 P16, 000 4, 800 P11, 200

Less income taxes Net disadvantage to stockholders Profitability Ratios for Stocks

6, 000

14, 000 (P 2, 800)

Number of measurements can be computed to evaluate the market value or price of a stock, and thus assist investors in deciding whether to buy or sell the stock of a certain company. These ratios include the following: 1. Earnings per share 2. Dividends per share 3. Book values per share 4. Price-earnings ratio 5. Dividend yield 6. Dividend payout ratio Earnings per share The earnings per share measures the amount of earnings applicable to each share of common Net income Preferred dividends Average number of common shares Outstanding The preferred dividends is subtracted from net income to obtain the income applicable to common stock. The preferred dividends refers to the total dividends paid during the year. If preferred stock is cumulative, the annual dividend requirement is subtracted even if not yet paid. Earnings per share = The earnings per share for the Soliman Co. are: Net income Less preferred dividends paid Income applicable to common stock Number of common shares outstanding Earnings per share 19B P199, 500 _ 7, 000 P192, 500 15, 000 P 12.83 19C P306, 800 __ 7, 000 P 299, 800 20, 000 P 14.99

Investors generally look at the earnings per share data of a company before buying shares of stock. A company with a history of high or increasing earnings per share is a profitable company and investors are more predisposed to buy shares of stock of that company. The publication of the earnings per share is also eagerly awaited by investors, and the news of a high earnings per share gives rise to expectations of a price for the stock of a company or of a larger dividends. Dividends per share The dividends per share, next to the earnings per share, is the figure that most investors are particularly interested in. It is computed by dividing the total dividends paid by the number of common shares outstanding.

The dividends per share paid by the Soliman Co. for 19B and 19C are computed on the following page. Book values 19B 19C Total dividends paid on common stock P180, 500 P201, 800 Number of common shares outstanding 15, 000 20, 000 Dividends per share P12.03 P10.09 Books values per share The book value or equity per share is the net assets per share of stock. The net assets are equal to total assets less total liabilities. The book value per share is the amount that each share of stock would receive if the assets of the business were sold at book value, that is, without loss or gain, and the liabilities paid at their recorded amounts. Under these assumptions, the cash that would exactly be equal to the total stockholders equity shown on the balance sheet. When there is only one class of stock, the book value per share is computed as follows: Book value per share = Total stockholders equity___ Number of shares outstanding

When there are two classes of stock, preferred and common, the total stockholders equity would be allocated to the two classes. The book values per share of each class of stock would then be computed as follows: Book value per share of preferred stock Stockholders equity applicable to Preferred stock___________ Number of preferred shares outstanding Total stockholders equity Equity ___applicable to preferred stock______ Number of common shares outstanding

Book value per share of common stock

The equity of the preferred stockholders consists of the liquidation value of preferred stock plus any dividends in arrears if the preferred stock is cumulative and participating dividends if the preferred stock is participating. Assuming that the preferred stock has a liquidation value equal to its par value, and the stock is neither cumulative nor participating, the book values per share for the Soliman Co. Would be computed as follows: 19B 19C Total stockholders equity P498, 000 P646, 000 Less equity preferred: Liquidation value 1, 000 shares at P100 100, 000 100, 000 Equity applicable to common P398, 000 P546, 000 Book values per share:

Preferred stock P 100. 00 P100. 00 Common stock 26.53 27.30 Price-earnings ratio The price-earnings (P/E) ratio, also called earnings multiple, indicates how much investors are willing to pay for the earnings of a company. A P/E ratio of say, 10:1 would mean that investors are willing to pay 10 times the earnings per share of a company for one share of stock. Price-earnings ratios generally vart from company to company. The average price-earnings ratio for stocks traded in the stock market also varies over several years depending, for example, on general business conditions. The price-earnings ratio, however, is usually used to judge whether a stock is undervalued or overvalued. The price-earnings ratio is calculated as follows: Price-earnings (P/E) ratio = Market price per share Earnings per share The current market price of a share of stock is normally used in the formula. Assuming that the market prices of the common stock of the Soliman Co. at the end of 19B and 19C are P80.00 and P100.00, respectively, the price-earnings ratios for the Soliman Co. would be: 19B P80.00 12.83 6.24 19C P100.00 14.99 6.67

Market price per share Earnings per share Price-earnings ratio

Dividend yield The dividend yield on common stock is the rate of return on the current market value of common stock. This rate is of particular interest to investors who favour regular cash returns on their investments or to those whose objectives are to maximize the yield on their investments. The dividend yield on common stock is calculated by the following formula: Dividend yield = Dividends per share__ Market price per share The yields on common stock for the Soliman Co. for 19B and 19C are: 19B P12.03 80.00 15.04% 19C P10.09 100.00 10.09%

Dividends per share Market price per share Dividend yield

Dividend-payout ratio The payout ratio, or payout percentage, indicates how much of the earnings per share has been distributed to stockholders in the form of dividends. It is calculated by dividing the common dividends per share by the earnings per share. The payout ratios for the Soliman Co. for the years 19B and 19C are: Dividends per share Earnings per share Payout ratio P12.03 12.83 .94 P10.09 14.99 .67

A payout percentage of 67 percent means that the company distributed 67 percent of the earnings per share to stockholders as dividends. A low payment ratios is not generally regarded favourably by most investors who expect companies to pay out larger dividends. On the other hand, some investors give primary consideration to the appreciation in value of their stocks. A low payout ratio means the earnings are being retained in the business for expansion purposes, which could lead to higher future earnings and to a higher value for the stock of a company. Thus, many investors would prefer to buy shares of stock of growth companies which generally have low dividend payout ratios.

Ratios Measuring Stability Stability, or long-term solvency, ratios measure the safety of the investments of creditors and the a business and the investments of creditors and the stockholders of a business and the ability of the business to pay interest, dividends, and other fixed charges. The stability of a business is measured or analyzed through ratios related to the following: 1. The capital structure of the business 2. The asset coverage of long-term debt 3. The earnings coverage of fixed charges. Capital Structure analysis The capital structure of a business consists of its debt and equity capital. The sources of debt capital are the creditors, while equity capital specifically refers to capital provided by the owners or stockholders. The relative size of debt and equity in the capital structure of a business can be determined by the following two ratios: Debt ratio = Total liabilities Total assets Total stockholders equity Total assets

Equity ratio

The debt ratio gives the proportion of total funds supplied by creditors while the equity ratio indicates the proportion of total funds provided by stockholders. The sum of the two ratios should equal to 100 percent. For example, if the debt ratio is 55 percent, the equity ratio must be 45%. A high debt ratio means that a business is making extensive use of debt, or leverage, while a high equity ratio means that a business relies more on capital provided by owners. Generally, a higher proportion of equity capital in the total capital of a business is preferable. A business with a high proportion of debt in its capital structure is subject To greater risks of bankruptcy and is more vulnerable to business declines. On the other hand, a business with a very high equity ratio means that the business is not taking advantage of leverage. Calculations of the debt and equity ratios for the Soliman Co. are presented below. Total liabilities Total stockholders equity P556, 000 498, 000 P442, 000 646, 000

Total assets Debt ratio Equity ratio

1,054,000 .53 .47

1,088, 000 .41 .59

The capital structure may also be analyzed by relating the debt capital and equity to each other instead of the total assets. The relationships can be expressed in the following ratios: Debt-to-equity ratio = ____Total liabilities_____ Total stockholders equity Total stockholders equity Total liabilities

Equity-to-debt ratio

The above ratios are computed for the Soliman Co. below. 19B Total liabilities P556, 000 Total stockholders equity 498, 000 Debt-to-equity ratio 1.12:1 Equity-to-debt ratio .90:1

19C P442, 000 646, 000 .68:1 1.46:1

A debt-to-equity ratio of .68:1 means that total debt is approximately two-thirds of the amount of equity capital. Ratio of plant and equipments to long-term debt The protection afforded to long-term creditors can be measured by the ratio of plant and equipment to long-term debt. Plant and equipment are related to long-term debt as long-term creditors provide funds on the security of long-term assets. The amount of additional credit a business could obtain also depends on the amount of available security. A business with a low coverage of its long-term debt would find difficulty obtaining additional credit, while a business with assets more than sufficient to cover existing debt can more easily secure additional financing from creditors. The ratios are computed for the Soliman Co. as follows: 19B Plant and equipment (net) P715, 000 Long-term debt 400, 000 Ratio of plant and equipment to longterm debt 1.79:1

19C P750, 000 300, 000 2.50:1

The book values of plant and equipment have been used in the above computations. When the fair market values or appraised values of plant and equipment are available, these should be used in computing the ratios since long-term creditors base the amount of credit that could be granted to borrowers on the appraised values of properties offered as collaterals. Also, the appraised values would represent the amounts that would be available to pay creditors if the assets were to be sold. Earnings coverage of fixed charges

The ability of a business to meet its fixed charges out of current earnings is measured by the following ratios: 1. Times interest earned 2. Times preferred dividends earned 3. Times interest and preferred dividends earned 4. Times all fixed charges earned. Times interest earned The ability of the business to meet interest payments on long-term debt is measured by the number of times interest requirements were earned. The times interest earned ratio is calculated as follows: Net income before taxes Times interest earned = Interest expense Interest expense Interest expense is deducted from operating income in getting the net income before taxes. To determine the amount available before taxes for the payment of interest, interest expense is added back to net income before taxes. For the Soliman Co. the times interest earned in 19B and 19C are: 19B Net income before taxes P285, 000 Add interest expense 25, 000 Net income before interest and taxes P310, 000 Interest expense 25, 000 Times interest earned

19C P472, 000 20, 000 P492, 000 20, 000

The net income after taxes is sometimes used in computing the times interest earned. In this case, interest expense is added to net income after taxes in getting the numerator. The result using this procedure is a more conservative figure than that obtained by the above formula. Times preferred dividends earned The ability of the business to pay dividends to preferred stockholders is measured by the number of times preferred dividends were earned is: Times preferred dividends earned = Net income after taxes____ Annual preferred dividends

The calculations for the Soliman Co. are: Net income Preferred dividends Times preferred dividends earned Times interest and preferred dividends earned 19B P199, 500 7, 000 28.50 19C P306, 800 7, 000 43.83

The number of times that both interest and preferred dividend requirements were earned can be computed as follows: Net income before taxes Times interest and Interest expense___ Preferred dividends = interest expense Preferred dividends earned 1-Tax rate Preferred dividends can be paid only after taxes have been met. To obtain the amount required to pay dividends before taxes, the preferred dividends are divided by the complement of the tax rate, or by 1 less the tax rate. The ratios for the Soliman Co. are developed as follows: 19B Net income before taxes P285, 000 Interest expense 25, 000 Net income before interest and taxes P310, 000_ Preferred dividends: 19B P7, 000 (1 - .30) 10, 000 19C P7, 000 (1 - .35) ______ Total 35, 000 Times interest and preferred dividends earned 8.86

19C P472, 000 20, 000 P492, 000

10, 769 30, 769 15.99

Times all fixed charges earned Interest expense and preferred dividends may not represent the only fixed charges of a business. Some companies may have other fixed charges like rental payments and principal payments. The number of times that all fixed charges were earned can be determined in a manner similar to the computation of the times interest and preferred dividends were earned. The income before taxes and before all fixed charges are deducted would be divided by all the fixed charges, as shown below. Times all fixed charges earned QUESTIONS 1. What is financial statement analysis? 2. State the objectives of financial statement analysis? 3. Who are the parties interested in analysis and interpretation of financial statements? In what aspects of financial statement analysis are they interest in? 4. What are the basic tools of financial statement analysis? Give the advantages of each? 5. What are the comparative statements? What are the advantages of comparative statements over single-period financial statements. 6. How are financial statements of two or more periods compared? 7. Distinguish between horizontal analysis and vertical analysis? 8. What are common-size financial statements? 9. Define the concept of liquidity. = Net income before taxes Fixed charges Fixed charges

10. What factors would one look into in analyzing th liquidity of a business? 11. How does the current ratio differ from the acid-test (quick ratio)? What is the significance of each ratio? 12. What is meant by a turnover rate? How are turnover rates interpreted? 13. What measurements may be developed in analyzing the (a) receivable position and (b) the inventory position of a business? 14. Define the operating cycle of a business. How is the length of the operating cycle approximated? 15. State the ratios that are useful in developing the profitability of a business in relation to (a) sales and (b) the investments. 16. What are the two component rates of the rate in return on total assets? How are the two rates related? 17. What is meant by the concept of leverage, or trading on the equity? 18. Give the measurements that may be used in evaluating the worth of a stock. Indicate the computation and the significance of each ratio. 19. What factors are involved in analyzing the long-term solvency of a business? 20. Is profitability related to stability of a business? Explain. 21. What does the capital structure of a business refer to? How are the capital structure ratios expressed? 22. How is the asset coverage of long-term debt measured? 23. How are the times interest earned and the times preferred dividends earned ratios computed? 24. State some limitations of financial statement analysis? EXERCISES 1. For the cases given below, indicate the peso amount of increase or decrease, the percentage increase or decrease, and the ratio, whenever applicable. 19B P20, 000 25, 000 (10, 000) 30, 000 60, 000 (20, 000) 10, 000 40, 000 25, 000 (70, 000) 19C P30, 000 10, 000 50, 000 60, 000 (90, 000) (30, 000) 25, 000 40, 000 20, 000 (35, 000)

a. b. c. d. e. f. g. h. i. j.

Sales Operating expenses Cash Allowance for depreciation Retained earnings Net loss Treasury stock Premium on common stock Accounts payable Working capital

2. Selected data for the Zeny Corporation over a period of five years are presented below. 19A P150, 000 40, 000 19B P202, 500 70, 400 19C P216, 000 88, 000 19D P238, 500 81, 600 19E P258, 000 74, 800

a. Sales b. Net income

c. Earnings per share 2.00 d. Total liabilities 400, 000 e. Total assets 750, 000

1.92 380, 000 757, 000

2.10 368, 000 772, 000

1.88 372, 000 765, 000

2.24 360, 000 780, 000

Required: compute the trend percentage or index numbers for the above data using 19A as the base year. Comment on the trend percentages. 3. The condensed income statements of ABC Co. and XYZ Co. which are both engaged in the textile merchandising business, are presented below. ABC Co. P400, 000 288, 000 P112, 000 72, 000 P 40, 000 12, 000 P 28, 000 XYZ Co. P600, 000 408, 000 P192, 000 144, 000 P 48, 000 15, 000 P 33, 000

Net sales Cost of goods sold Gross profit Operating expenses Operating income Income taxes Net income

Required: Prepare common-size income statements for the two companies. Interpret the differences. 4. The balance sheets of the Tamayo Co. for two years are shown below. 19A Assets Cash Accounts receivable Inventories Plant, assets, net Total assets Liabilities and Stockholders Equity Accounts payable Accrued expenses Common stock Retained earnings Total liabilities and stockholders equity P21, 000 32, 000 55, 000 120, 000 P228, 000 P26, 000 43, 000 62, 000 138, 000 P269, 000 December 31 19B

P 44, 000 18, 000 150, 000 16, 000 P228, 000

P 52, 000 21, 000 160, 000 36, 000 P269, 000

Required: Prepare common balance sheets for the year years for the Tamayo Co. 5. Selected information from the records of the Santos Company is presented below.

Cash Dividends payable Temporary investments Long-term investments Accounts receivable Inventories Interest receivable Prepaid insurance Advances from customers Income taxes payable Accounts payable Unearned rental income Deferred income taxes Cash surrender value of Life insurance Required: (1) Compute the working capital of the Santos Company. (2) Compute the current ratio. (3) Compute the quick ratio.

P16, 000 6, 000 9, 000 12, 000 10, 000 18, 000 3, 000 1, 000 5, 000 4, 000 15, 000 8, 000 7, 000 20, 000

6. The following accounts were taken from the records of the Demetrio Company: Year 3 P300, 000 600, 000 20, 000 15, 000 40, 000 60, 000 Sales returns and Year 4 P350, 000 700, 000 30, 000 18, 000 60, 000 80, 000 allowances apply

Cash sales Credit sales Sales discounts Sales returns and allowances Accounts receivable, beginning Account receivable, end The sales discounts apply only to credit sales. proportionately to cash sales and credit sales. Required: (1) (2) (3) (4)

Determine the accounts receivable turnover for Year 3 and Year 4. Determine the numbers of days in average receivables for both years assuming a 300 day Determine the number of days sales in receivables at the end of each year. Comment on the changes in the ratios in Year 4 as compared with Year 3.

7. The following information applicable to the Corazon Co. is available: 19A 19B 19C

Net credit sales Accounts receivable (net) Allowance for bad debt Sales discounts

P600, 000 70, 000 10, 000 5, 000

P720, 000 90, 000 15, 000 8, 000

P900, 000 115, 000 25, 000 12, 000

Required: (1) Compute the accounts receivable turnovers for 19B and 19C. (2) Compute the number of days sales in average receivables for the two years (assume a business year of 360 days). 8. The cost of goods sold statements of the Sto. Tomas Co. for the years ended December 31, 19A and 19B are reproduced below. Year Ended December 31 19A 19B Direct Materials: Materials inventory, beg. P 10,000 P 20,000 Purchases 60,000 80,000 Materials available for use P 70,000 P100,000 Materials inventory, end 20,000 40,000 Raw materials used P 50,000 P 60,000 Direct labor 25,000 30,000 Factory overhead 15,000 18,000 Total manufacturing costs P 90,000 P108,000 Work in process inventory, beg. 18,000 24,000 P108,000 P132,000 Work in process inventory, end 24,000 28,000 Cost of goods manufactured P 84,000 P104,000 Finished goods inventory, beg. 30,000 20,000 Total goods available for sale P114,000 P124,000 Finished goods inventory, end 20,000 22,000 Cost of goods sold P 94,000 P102,000 ----------------------Required: Compute for 19A and 19B the following ratios related to inventories: (a) Turnover of raw materials, work in process, and finished goods. (b) Number of days per turnover of raw materials, work in process, and finished goods. Assume a 360-day year. 9. The following incomplete data have been obtained from the records of the Lucky Star Company: 19A 19B Cost of goods sold P160,000 Cost of goods manufactured 240,000 Goods available for sale 200,000 Finished goods inventory, beginning 20,000 Finished goods inventory, end 50,000

Required: (1) Compute the finished goods turnover for 19A and 19B. (2) Compute the number of days per turnover of finished goods for both years (assume a 360-day year). 10. Form the following data, determine the average number of days required to convert raw materials into cash (assume a business year consisting of 360 days). Raw materials used Cost of goods sold Net credit sales Average raw materials inventory Average finished goods inventory Average accounts receivable 11. Data on net income, sales, and total assets for the Excelsior Co. are given below. Year 7 P 112,000 1,400,000 490,000 510,000 Year 8 P 116,480 1,820,000 510,000 530,000 P360,000 420,000 800,000 40,000 70,000 80,000

Net income Sales Total assets, beginning of year Total assets, end of year

Required: For both Year 7 and Year 8, compute: (1) The rate of return on net sales. (2) The assets turnover rate. (3) The rate of return on total assets as a product of the rate of return on net sales and the assets turnover rate. 12. The Olivia Co.s stockholders equity on December 31, Year 8 appeared as follows: P 500,000 1,000,000 150,000 P1,650,000 -------------The net income of the company for the year was P175,000. During the year, the company paid the stated dividend rate on the preferred stock plus P100,000 on the common stock. The market price per share of common stock on December 31, Year 8 was P25,000. Required: Compute the following ratios: (1) Earnings per share. (2) Dividends per share. 10% Preferred stock Common stock, P20 par Retained earnings Total

(3) (4) (5) (6)

Price-earnings ratio. Dividend-payout ratio. Dividend yield on common stock. Book value per share.

13. Data on the capital structure and income of a company for two consecutive years are presented below. Year 9 Year 10 Current liabilities P 80,000 P100,000 8%bonds payable 200,000 Common stock 120,000 120,000 Retained earnings 200,000 205,000 P400,000 P625,000 ----------------------Net income P 56,000 ----------P 78,000 ------------

Required: (a) Compute for each year the following ratios: (1) Debt ratio (2) Equity ratio (3) Rate of return on total assets at the end of each year. (4) Rate of return on stockholders equity at the end of each year. (b) Comment on the rate computed above. 14. The Sanchez Sales Co. reported a net income of P140,000 for the current year after an income tax expense of P60,000. The company had the following capital structure at the end of the year: 10% Bonds Payable 8% Preferred stock Common stock Retained earnings P400,000 200,000 500,000 100,000

Required: (a) Compute the number of times interest was earned during the year. (b) Compute the number of times preferred dividends were earned during the year. 15. Indicate for each of the following transactions whether the given transaction will increase, decrease, or have no effect on the current ratio: (1) (2) (3) (4) Sale of marketable securities at a gain. Payment on accounts payable (assume a ratio of at least 1:1 before the payment). Collection of accounts receivable at a discount. Write-off of an account receivable.

(5) Payment of interest on short-term notes payable.

16.

State the effect of each of the following transactions on the corresponding ratio listed on the right-hand column. Will the transact n increase, decrease, or have no effect on the indicated ratio? Transaction (1) Issuance of long-term note in exchange for land. (2) Conversion of long-term debt into common stock. (3) Purchase of treasury stock. (4) Appropriation of retained earnings. (5) Declaration of cash dividends on cumulative preferred stock. (6) Purchase of merchandise on account. (7) Reclassification of long-term liability to current liability. (8) Decrease in market price of stock. (9) Increase in selling price of a companys product. (10)Write-off of a patent. Ratio Debt ratio Debt-to-equity ratio Equity ratio Book value per share Earnings per share Quick ratio Current ratio Price-earnings ratio Gross profit rate Rate of return on total assets

17. The following information has been derived from the financial statements of the Sunrise Company for the year 19C: Inventory turnover Rate of return on sales Gross profit rate Operating expense ratio Times interest earned Merchandise inventory 20 times 14% 40% 19% 21 times P24,000

Required: From the above information, reconstruct the income statement of the Sunrise Co. for the year ended December 31, 19C. 18. The following data for the Armando Co. are available: Armando Company Selected Financial Data As of December 31, 19B P 75,000 225,000 270,000 19A P 35,000 200,000 210,000

Cash Accounts receivable (net) Merchandise inventory

Short-term marketable securities Land and building (net) Mortgage payable-current portion Accounts payable and accrued liabilities Short-term notes payable

40,000 500,000 30,000 120,000 50,000

20,000 500,000 25,000 110,000 70,000

Year Ended December 31 19B 19A Sales Cost of goods sold 1. a. b. c. d. Armandos quick (acid test ratio) as of December 31 19B is 3.6 to 1 3.1 to 1 2.0 to 1 1.7 to 1 P1, 500, 000 900, 000 P1, 300, 000 800, 000

AICPA

2. Based on a business year consisting of 300 days, what was the number of days sales in average inventory for 19? a. 80 b. 70 c. 54 d. 48 19. Wal Corporations books disclosed the following information as of and for the year ended December 31, 19A: Net credit sales P3, 000, 000 Net cash sales 480, 000 Accounts receivable at beginning 400, 000 Accounts receivable at end 800, 000 Wals accounts receivable turnover is a. 3.75 times b. 4.35 times c. 5.00 times d. 5.80 times

AICPA

20. During 19A, Carmelita Company purchased P1, 200, 000 of inventory. The cost of goods sold for 19A was P1, 320, 000 and the ending inventory at December 31, 19A was P240, 000. What was the inventory turnover for 19A? a. 4.0 b. 4.4 c. 5.0 d. 5.5 AICPA

21. Selected information from the accounting records of Dalton Manufacturing Company is as follows: Net sales P1, 800, 000 Cost of goods sold for 19B 1, 200, 000 Inventories at December 31, 19A 336, 000 Inventories at December 31, 19B 288, 000 Assuming there are 300 working days per year, what is the number of days sales in average inventories for 19B? a. 78 b. 72 c. 52 d. 48 AICPA 22. Selected information for Carmen Corp. For the year ended December 31, 19A follows: Average days sales in inventories Average days sales in accounts receivable The average number of days in the operating cycle for 19A was a. 172 b. 124 c. 86 d. 76 AICPA 23. At December 31, 19A, Rimalos Company had 100, 000 shares of P10 par value common stock issued and outstanding. There was no change in the number of shares outstanding during 19B. Total stockholders equity at December 31, 19B was P2, 800, 000. The net income for the year ended December 31, 19B. What was the price-earnings ratio on common stock for 19B? a. 3.0 to 1 b. 3.5 to 1 c. 4. 8 to 1 e. 8.0 to 1 AICPA 24. On December 31, 19A and 19B, Tiger Corporation had 100, 000 shares of common stock and 50, 000 shares of noncumulative and nonconvertible preferred stock issued and outstanding. Additional information follows: Stockholders equity at 12/31/19B Net income year ended 12/3 1/19B Dividends on preferred stock year ended 12/31/19B P4, 500, 000 1, 200, 000 300, 000 124 48

Market price per share of common stock at 12/31/19B The price-earnings ratio on common stock at December 31, 19B was a. 5 to 1 b. 6 to 1 c. 8 to 1 f. 9 to 1 25. The following data are available: Apex Corporation SELECTED FINANCIAL DATA YEAR ENDED DECEMBER 31, 19A Operating income Interest expense Income before income tax Income tax expense Net income Preferred stock dividends Net income available to common stockholders Common stock dividends 1. The times interest earned ratio is a. 2.8 to 1 b. 4.8 to 1 c. 8.0 to 1 d. 9.0 to 1 2. The times preferred dividend earned ratio is a. 1.4 to 1 b. 1.7 to 1 c. 2.4 to 1 d. 4.0 to 1 P900, 000 100, 000 800, 000 320, 000 480, 000 200, 000 P280, 000 P120, 000

72

AICPA

AICPA

26. For each of the following numbered items, you are to select the letter that indicates its effects on the corporations statements. Indicate your choice by giving the letters identifying the effects that you select. If there is no appropriate response among the effects is applicable to a particular item, be sure to list all applicable letters. (Assume that statutes do not permit the declaration of non liquidating dividends except from earnings.) Item Declarations of a cash dividend due in one month on preferred stock Declaration and payment of an ordinary stock dividend Receipt of a cash dividend, not previously recorded, on stock of another corporation Passing of a dividend on preferred stock Receipt of preferred shares as a dividend on stock Effect A. Reduces working capital B. Increases working capital C. Reduces current ratio D. Increases current ratio E. Reduces the peso amount of total capital stock F. Increases the peso amount of total capital stock

(1) (2) (3) (4) (5)

held as temporary investment. This was not a regularly recurring dividend

G. Reduces total retained earnings H. increases total retained Earnings I. Reduces equity per share of common stock J. Reduces equity of each common stockholder

(6) Payment of dividend mentioned in (1) (7) Issue of new common shares in a 5-for-1 stock split 27. The December 31, 19A balance sheet of Ratio Inc. Is presented below. These are the only accounts in Ratios balance sheet. Amounts indicated by a question mark (?) can be calculated from the additional information given. Assets Cash Accounts receivable (net) Inventory Property, plant and equipment (net) P25, 000 ? ? 294, 000 P432, 000

Liabilities and Stockholders Equity Accounts payable (trade) Income taxes payable (current) Long-term debt Common stock Retained earnings Additional information: Current ratio (at year end) Total liabilities divided by total stockholders equity Inventory turnover based on sales and ending inventory Inventory turnover based on cost of goods sold and ending inventory Gross margin for 19A P ? 25, 000 ? 300, 000 ?____

1.5 to 1 .8 15 times 10.5 times P315, 000

(1) What was Ratios December 31, 19A balance in trade accounts payable? a. P67, 000 b. P92, 000 c. P182, 000 d. P207, 000 (2) What was Ratios December 31, 19A balance in retained earnings? a. P60, 000 deficit b. P60, 000 c. P132, 000 deficit

d. P132, 000 (3) What was Ratios December 31, 19A balance in the inventory account? a. P21, 000 b. P30, 000 c. P70, 000 d. P135, 000 AICPA PROBLEMS 3.1 Presented below are the income statements of the Amex Co. for the years ended December 31 19C and 19D. 19C P245, 000 4, 000 P241, 000 135, 000 P106, 000 35, 000 28, 000 63, 000 P 43, 000 2, 000 P 41, 000 12, 000 P 29, 000 19D P260, 000 3, 000 P257, 000 132, 000 P125, 000 40, 000 23, 000 63, 000 P 62, 000 3, 000 P 59, 000 17, 000 P 42, 000

Gross sales Sales returns and allowances Net sales Cost of goods sold Gross profit Operating expenses: Selling General and administrative Total operating expenses Operating income Interest expense Net income before income tax Income tax Net income

Required: (a) Prepare a comparative income statement including a horizontal analysis. Show peso and percentage changes for 19B as compared with 19A. (b) Prepare a comparative income statement including a vertical analysis. Express revenue and expense items in terms of net sales for each year. 3.2 The condensed balance sheets of the Ace supply Company at the end of 19A and 19B are as follows: December 31 19A Assets Current assets Investments Plant assets, net Intangible assets Other assets Total assets P540, 000 300, 000 960, 000 150, 000 80, 000 P2, 030, 000 P520, 000 310, 000 940, 000 120, 000 100, 000 P1, 990, 000 19B

Liabilities Current liabilities Long-term liabilities Other liabilities Total liabilities Stockholders Equity Preferred stock Common stock Additional paid-in capital Retained earnings Total stockholders equity Total liabilities and stockholders equity P300, 000 500, 000 50, 000 580, 000 P1, 430, 000 P2, 030, 000 P300, 000 600, 000 60, 000 335, 000 P1, 295, 000 P1, 990, 000 P230, 000 300, 000 70, 000 P600, 000 P245, 000 400, 000 50, 000 P695, 000

Required: (a) Prepare a comparative balance sheet including a horizontal analysis showing peso and percentage changes. (b) Prepare a comparative balance sheet including a vertical analysis. 3.3 Financial statements for the Winston Co., a manufacturing enterprise, are presented below. Winston Company Balance Sheet December 31, Year 5 Assets Cash Marketable securities Accounts receivable (net) Raw materials inventory Work in process inventory Finished goods inventory Prepaid expenses Property, plant, and equipment (net) Total assets Liabilities Accounts payable Accrued expenses Income taxes payable Cash dividends payable 12% Bonds payable Deferred income taxes Total liabilities Stockholders Equity P45, 000 36, 000 26, 000 20, 000 200, 000 30, 000 P357, 000 P65, 000 24, 000 35, 000 40, 000 18, 000 70, 000 14, 000 640, 000 P906, 000

Common stock Additional paid-in capital Retained earnings Total stockholders equity Total liabilities and stockholders equity Winston Company Income Statement For the Year Ended December 31, Year 5 Sales Less Sales discounts Sales returns and allowances Net sales Less cost of sales: Raw materials inventory, Jan. 1 Purchases Materials available for use Raw materials inventory, Dec. 31 Raw materials used Direct labor Factory overhead Total manufacturing costs Work in process inventory Jan. 1 Total goods placed in process Work in process, Dec. 31 Cost of goods manufactured Finished goods inventory, Jan. 1 Total goods available for sale Finished goods inventory, Dec. 31 Cost of goods sold Gross profit on sales Operating expenses Operating income Other revenues and expenses (net) Income before income taxes Net income P15, 000 20, 000

P360, 000 42, 000 147, 000 549, 000 P906, 000

P975, 000 35, 000 P940, 000

P30, 000 268, 000 P298, 000 40, 000 P258, 000 226, 000 163, 000 P647, 000 16, 000 P663, 000 18, 000 P645, 000 75, 000 P720, 000 70, 000 P650, 000 P290, 000 140, 000 P150, 000 35, 000 P185, 000 65, 000 P120, 000

Required: Compute the following: (1) Working capital (2) Quick (acid test) ratio (3) Current ratio (4) Accounts receivable turnover, assuming all sales on account (5) Number o days sales in ending receivables, assuming a 300-day business year (6) Turnover of raw materials inventory

(7) Turnover of work in process inventory (8) Turnover of finished goods inventory (9) Number of days sales in average finished goods inventory (10) Accounts payable turnover assuming all purchases on account (11) Number of days purchases in ending accounts payable (12) Current assets turnover (assume depreciation for the year was P32, 000) 3.4 The following data relating to the operations and sources of capital of the Domingo Company are available: 19A 19B Income statement data: Net sales P1, 200, 000 P1, 500, 000 Cost of goods sold 600, 000 825, 000 Operating income 252, 000 285, 000 Net income before taxes 120, 000 140, 000 Net income 90, 000 105, 000 Balance sheet data: Total liablilities P 400, 000 P 175, 000 6% Preferred stock 200, 000 200, 000 Common stock 225, 000 400, 000 Retained earnings 75, 000 100, 000 Requirements: (1) Compute the following ratios for 19A and 19B: (a) Gross profit rate (b) Rate of return on sales (c) Operating expense ratio (d) Operating margin ratio (e) Rate earned on total assets (f) Rate earned on total stockholders equity (g) Rate earned on common stockholders equity (h) Assets turnover rate (2) Comment on the various rates computed in (1). 3.5 The capital structures of two companies as of December 31, 19A appear as follows: Co. A Co. B 10% Bonds payable P100, 000 P Common stock, par value, P50 100, 000 200, 000 P200, 000 P200, 000 Required: (1) Compute the rate of return on common stockholders equity for both companies under each of the equity for both companies under each of the following independent assumptions with respect to operating income (assume an income tax rate of 35%). (a) P36, 000 (b) P20, 000 (c) P14, 000

(2)Compute the earnings per share for the two companies under each of the assumptions given in (1). 3.6 The balance sheet on December 31, 19C and the statement of income and retained earnings for the year ended December 31, 19C of the Warlito Company are presented on the following page. Warlito Company Balance Sheet December 31, 19C Assets Cash Marketable securities Accounts receivable Inventories Prepaid expenses Land Building (net) Equipment (net) Other assets Total assets Liabilities and Stockholders Equity Accounts payable Notes payable Accrued expenses 12% Bonds payable 8% Preferred stock Common stock Retained earnings Total liabilities and stockholders equity P 149,000 173,000 147,000 150,000 100,000 200,000 246,000 P 1,165,000 P 105,000 140,000 75,000 170,000 45,000 150,000 240,000 160,000 80,000 P1,165,000

Warlito Company Statement of Income and Retained Earnings For the Year Ended December 31, 19C Net sales Cost of goods sold Selling expenses General and administration expenses Internet expense Total expenses Income before income taxes Income taxes Net income Retained earnings, beginning of year Dividends Preferred P 8,000 P 600,000 P 347,000 56,000 32,000 18,000 P 480,000 P 120,000 4,200 P 78,000 200,000 P 278,000

Common Retained earnings, end of year

24,000

32,000 P 246,000

Required: From the above data, compute the following ratio: (1) Debit ratio (2) Equity ratio (3) Dept-to-equity ratio (4) Ratio of stockholders equity to plant and equipment (5) Times interest earned (6) Times preferred dividends earned 3.7 Presented below are data related to two companies whose shares of stock are listed on a stock exchange: MRC CO. APC CO. Sales P2, 400,000 P1, 875,000 Net income 190,000 160,000 Total assets 1,330,000 1,210,000 Market price of stock at year-end 60.00 25.00 Cash dividends per share 3.00 1.20 Liabilities 600,000 560,000 Preferred stock 300,000 100,000 Preferred dividends rate 8% 10% Common stock 200,000 300,000 Paid-in capital in excess of par-common 50,000 40,000 Retained earnings 180,000 210,000 Common shares outstanding 20,000 30,000 Required: (1) For each company, compute the following ratios: (a) Earnings per share (b) Dividends yield (c) Price-earnings ratio (d) Dividends-payout ratio (e) Book value per share of common stock (2) Compare and comment on the ratios computed for the two companies. 3.8 Income statements and balance sheets of the Benny Company for 19A are given in considered form below. Income Statement Year Ended December 31 19A Net sales Cost of goods sold Gross profit Operating expenses Operating income P28, 000 190, 000 P 70, 000 30, 000 P 40, 000 December 31 P280, 000 200, 00 P 80, 000 45, 000 P 35, 000

Interest expense Interest income Income before income taxes Income taxes Net income

(10, 000) 4, 000 P 34, 000 6, 000 P 28, 000

(10, 000) 3, 000 P 28, 000 5, 000 P 23, 000

Balance Sheet Assets Cash Trade receivables (net) Inventories Prepaid expenses Plant and equipment (net) Intangibles Other assets Total assets December 31 19A 19B P42, 000 P60, 000 45, 000 70, 000 80, 000 85, 000 25, 000 30, 000 680, 000 690, 000 80, 000 110, 000 25, 000 35, 000 P977, 000 P1, 080, 000

Equities Accounts and notes payable Accrued expenses Income taxes available Cash dividends payable 10% Bonds payable 6% Preferred stock, cumulative, P100 par and liquidating value Common stock, P25 par Additional paid-in capital Retained earnings Total equities Required:

P48, 000 30, 000 47, 000 55, 000 100, 000 150, 000 250, 000 120, 000 177, 000 P977, 000

P72, 000 38, 000 49, 000 65, 000 100, 000 150, 000 300, 000 124, 000 182, 000 P1, 080, 000

From foregoing data, calculate the following ratios for 19A and 19B (Use the year-end balances); (a) Current ratio (b) Acid-test (quick) ratio (c) Turnover over of trade receivables (assume all sales on account) (d) Number of days sales in trade receivables at the end of each year( assume a 360-day business year) (e) Inventory turnover (f) Number of days sales in inventory at the end of each year (g) The operating cycle (in days) (h) The profit margin on sales (i) The gross profit rate (j) The rate earned on year-end total assets (k) The rate earned on year-end total stockholders equity (l) The rate earned on year-end common stockholders equity

(m) The equity ratio (n) The times interest earned (o) The times preferred dividends earned (p) The earnings per share (q) The book value per share of preferred stock (assume no dividends in arrears) (r) The book value per share to common stock. 3.8 The following data pertain to the financial statements of the Lotus Co. for the year ended December 31,19F: Net income Tax rate Rate of return on total assets (based on ending balance) Gross profit rate Assets turnover rate Equity ratio Ratio of current assets to total assets Current ratio P210, 000 30% 21% 45% 1.75% .60% .30% 1.50

Required: Prepare a condensed income statement of the Lotus Co. for the year ended December 31, 19F and a condensed balance sheet on December 31, 19F. The items to be shown on the balance sheet are Current assets, Plant and equipment, Current liabilities, Long-term liabilities, and stockholders equity. 3.9 Lucid Corporations management is concerned over the corporations financial position and return on investment. They request your assistance in analyzing their financial statements and furnish the following information: Schedule of Working Capital-December 31, 19A Current liabilities Less current assets: Cash Accounts receivable (net) Inventory Working capital deficit P223, 050 P 5, 973 70, 952 113, 125

190, 050 P33, 000

Lucid Corporation Income statement For the Year December 31, 19A Sales (90, 500 units) Cost of goods sold Gross profit Selling and general expenses, including Depreciation of P22, 980 Income before income tax Income tax Net income P760, 200 452, 500 P307, 700 155, 660 P152, 040 68, 418 P 83, 622

Assets other than current assets consist of land, buildings, and equipment with a book value of P352,950 on December 31, 19A. Sales of 100,000 units are forecasted for 19B. Within this relevant range of activity, costs are estimated as shown on the following page (excluding income tax).

Cost f goods sold Selling and general expenses, including Depreciation of P15, 450 Total

Fixed Variable costs Costs per unit__ P 4.90 P129,720 P129,720 -----------_1.10 P6.00 -------

The income tax rate is expected to be 40%. Past experience indicates that current assets very in direct proportion to sales. Required: (1) Assuming Lucid Corporation operates 300 days per year, compute the following (show your computations): (a) Number of days sales uncollected (b) Inventory turnover. (c) Number of days operations to cover the working capital deficit. (d) Return on total assets as a product of asset turnover and the net income ratio (sometimes called profit margin). (2) Management feels that in 19B the market will support a sales price of P8.30 at a sales value of 100,000 units. Compute the rate of return on book value of total assets after income tax assuming managements expectations are realized. AICPA 3.10 Financial analysis is often applied to test the reasonableness of the relationships among current financial data against those of prior financial data. Given prior financial relationships and a few key amounts, a CPA could prepare estimates of current financial data to test reasonableness of data furnished by a client. Golden harvest Company has in recent years maintained the following relationships among the data on its financial statements. Gross profit on net sales 40% Net profit rate on net sales 10% Rate of selling expenses to net sales 20% Accounts receivable turnover 8 per year Inventory turnover 6 per year Acid-test ratio 2 to 1 Current ratio 3 to 1 Quick asset composition: 8% cash, 32% marketable Securities, 60% accounts receivable Asset turnover 2 per year Ratio of total assets to intangible assets 20 to 1 Ratio of accumulated depreciation to Cost of fixed assets 1 to 3

Ratio of accounts receivable to accounts Payable Ratio of working capital to stockholders Equity Ratio of total liabilities to stockholders Equity

1.5 to 2 1 to 1.6 1 to 2

The corporation had a net income of P120, 000 for 19A, which resulted in earnings of P5.20 per share of common stock. Additional information includes the following: (a) Capital stock authorized, issued and outstanding: common, P10 per share par value, issued at 10% premium; 6% Preferred, P100 per share, issued at 10% premium. (b) Market value per share of common at December 31, 19A, P78. (c) Preferred dividends paid in 19A, P3, 000. (d) Number of times interest earned in19A, 21. (e) The amounts of the following were the same at December 31, 19A as at January 1, 19A: inventory, accounts receivable, 8% bonds payable-due 19C, and total stockholders equity. (f) All purchases and sales were on account.

Required: (1) Prepare in good form: (a) the condensed balance sheet, and (b) the condensed income statement for the year ending December 31, 19A, presenting the amounts you would expect to appear o Golden Harvests financial statements (ignoring income tax). Major captions appearing on Golden Harvests balance sheet are: Current assets, Fixed assets, Intangible assets, Current liabilities, Long-term liabilities and Stockholders equity. In addition to the accounts divulged in the problem, you should include accounts for prepaid expenses, miscellaneous expenses payable and administrative expenses. Supporting computations should be in good form. (2) Compute the following for 19A (show your computations): (a) Rate of return on stockholders equity. (b) Price-earnings ratio for common stock. (c) Dividends paid per share of common stock. (d) Dividends paid per share of preferred stock. (e) Yield on common stock. AICPA

Chapter 4 EARNINGS PER SHARE AND BOOK VALUES PER SHARE Earnings per share The earnings per share is widely published financial statistic. It is found annual reports to stockholders, prospectuses and proxy material, and is circulated through the press, statistical services, and other financial publications. Current accounting practice requires that the earnings per share be reported in the financial statements, particularly in the income statements of public enterprises. The procedures for computing earnings per share figures are likewise governed by accounting standards. Earnings per share is the amount of income earned during a given period that is applicable to each share of common stock. It is stated on a per share basis and is applicable only to common stock. The earnings per share is an important measurement from the point of view of common stockholders and prospective investors. Investors are earnings per share in evaluating the past operating performance of a business, in estimating its profitability, and in making investment decisions. These are two specific ways in which the earnings per share may, for example, be used by investors, namely; 1) The earnings per share may be used to compute the price-earnings ratio, which is obtained by dividing the market price share by the earnings per share. 2) The earnings per share may be divided into the dividends per share to arrive at what is called the payment ratio or percentage. Types of capital structure The computation of the earnings per share is dependent on the type of capital structure of a business. The capital structure of a business may be classified into two types: 1) A simple capital structure, and 2) A complex capital structure. A simple capital structure consists only of common stock, or common stock and other securities which do not have a potentially dilutive effect on earnings per share, like a nonconvertible preferred stock. A potentially dilutive security is ones which can cause a dilution or decrease in the earnings per share if such security is converted into or exchanged for common stock. Examples of securities which have a potentially dilutive effect on earnings per share are convertible bonds, convertible preferred stock, options, and warrants. A company with a complex capital structure has convertible bonds, convertible preferred stock, stock options, stock warrants, or other potentially dilutive securities. The conversion or exercise of these securities can lead to a decrease in the earnings per share or an increase in the loss per share. The investors need to be informed of this potential dilution in the earnings per share.

Simple capital structure If the capital structure of a business consists only of one class of stock, called common stock o capital stock, the earnings per share is computed by simply dividing the net income by the average number of shares of common stock outstanding. However, if in addition to the common stock, the capital structure also includes a nonconvertible preferred stock, the income applicable to the preferred stock should be subtracted from the total net income to obtain the income applicable to the common stock. The earnings per share would thus be computed using the following formula: Earnings per share = __Net income Preferred dividends__ Number of common shares outstanding

The amount deducted from net income is the preferred dividends paid or declared during the year. If the preferred stock is cumulative, the annual preferred dividends, whether declared or not, is to be deducted from net income. In case of a loss, the preferred dividends whether paid or cumulative, are added to the net loss in calculating a loss per share. To illustrate the computation of earnings per share, assume the following: On December 31, 19A, the Yellow Ribbon Company has outstanding 10, 000 shares of P100 per vale, 6% of P100 par value common stock. Net income during the year was P160, 000. The earnings per share of the Yellow Ribbon Company for 19A is calculated as follow: Net income Less preferred dividends (P1, 000, 000 x 6%) Net income applicable to common Divide by number of common shares outstanding Earnings per share Average number of shares outstanding The number of shares outstanding at the end of a period is used in computing the earnings per share if there are no changes in the number of shares outstanding during the period. However, the number of shares outstanding during the period may have changed as a result of additional issuances of common stock or reacquisition of outstanding shares. If changes in the number of common shares outstanding have occurred during the period, the use of the number of shares at the end of the period may not be representative of the number of shares outstanding during the year. Under these situations, it would be more meaningful to use a weighted average of the number of shares outstanding during the period. P160, 000 60, 000 P100, 000 50, 000 P 2.00

To illustrate, assume the following changes in the number of shares of common stock outstanding of a business: January 1 April 1 August 1 October 1 Outstanding, 10, 000 shares of common stock Issued 2, 000 shares of common stock Issued 3, 000 shares of common stock Reacquired 2, 000 shares of common stock

The weighted average number of shares outstanding during the period can be computed under two alternative methods. Under the first method, the number of shares issued for reacquired is multiplied by the fractional portion of the year that those shares issued or reacquired were outstanding in the case of issued shares or were not outstanding in the case of reacquired shares. The computation of the weighted average number of shares outstanding using this method is given below. Jan. 1 April 1 Aug. 1 Oct. 1 Dec. 31 10, 000 Dec. 31 2, 000 Dec. 31 3, 000 Dec. 31 2, 000 Weighted average number of shares outstanding x x x x 12/12 9/12 5/12 3/12 = = = = 10, 000 1, 500 1, 250 ( 500) 12, 250

The other method is to determine the total number of shares outstanding at any given period during the year and to multiply the total shares outstanding by the fractional portion of the year that the total number of shares remained unchanged. The calculation of the average number of shares outstanding following this procedure is shown below. Jan. 1 April 1 Aug. 1 Oct. 1 Mar. 31 10, 000 July 31 12, 000 Sept. 31 15, 000 Dec. 31 13, 000 Weighted average number of shares outstanding x x x x 3/12 4/12 2/12 3/12 = = = = 2, 500 4, 000 2, 500 3, 250 12, 250

Stocks dividends and stock splits The number of shares outstanding during a period may have changed as a result of a stock dividend or a stock split. A stock dividend or a stock split, however, does not affect the assets or income of a business. Consequently, stock dividends or stock splits are not really transactions which would require weighting for fractional periods in the computation of the average number of shares. What is necessary to be done, however, is to give retroactive recognition to the change in the number of shares. The retroactive recognition the change in the number of shares is made by restating the outstanding shares prior to the stock dividend or stock split in terms of the current capital structure. The restatement of prior

outstanding shares is necessary in order that the per share earnings of current and prior periods can be made comparable. To illustrate the computation of the average number of shares outstanding when there are stock dividends or stock splits, assume that a business had the following transactions during its first year of operations: Jan. 1 May 1 Dec. 1 Dec.31 Issued 12,000 shares of common stock Issued 3,000 shares of common stock Issued a 25% stock dividend Recorded a net income of P84,000.

The weighted average number of shares outstanding during the year and the earnings per are computed as follows: Jan. 1 Dec. 31 12,000 x 1.25 x 12/12 = 15,000 May 1 Dec. 31 3,000 x 1.25 x 8/12 = _2,500 weighted average number of shares 17,500 --------Earnings per share (P84,000 + 17,500) In computing the weighted average number of shares, all the actual number of shares issued prior to the stock dividend are increased by the stock dividend and then weighted for fractional periods. The stock dividend is also conveniently ignored in the determination of the fractional periods that the shares are outstanding. To continue the illustration, assume that the company had the following transactions during the second year: March 1 Issued 3,000 x 2 x 12/12 = 37,500 June 1 Issued a 2-for1 stock split Dec. 31 Recorded a net income of P65,000. The weighted average number of shares and the earnings per share for the second year are: Jan. 1-Dec. 31 18,750 x 2 12/12 = 37,500 March 1-Dec. 31 3,000 x 2 x 10/12 = 5,000 Weighted average number of shares 42,500 --------Earnings per share (P85,000 + 42,5000) P2.00 The earnings per share figures for the first year and the second year are not comparable. If the earnings per share for the two years were to be presented in comparative income statements, it would be necessary to restate the earnings per share previously computed for the first year. This involves a restatement of the number of shares outstanding during the first year. The computations are: Jan. 1 Dec 31 12,000 x 1.25 x 2 x 12/12 = 30,000 May 1 Dec. 31 3,000 x 1.25 x 2 x 8/12 = 5,000 Weighted average of current equivalent Shares 35,000 --------Earnings per share (P84,000 + 35,000) P2.40

Thus, the earnings per share figures to be presented in comparative income statements would be P2.40 for the first year and P2.00 for the second year. The retroactive adjustment of the stock split makes possible a valid comparison of the two earnings per share figures. Nonoperating items When the income statement of a business includes extra-ordinary items, income or loss from discontinued operations, or the cumulative effect of a change in accountings principle, the effect of each of these items on the earnings per share should be shown separately. There would thus be several components of the earnings per share. To present single earnings per share in the presence of nonoperating items would be misleading to readers of financial statements. To illustrate, assume that a company has a simple capital structure that consists of the following: 6% Preferred stock, par value, P100. Cumulative and nonparticipating, Issued, 10,000 shares Common stock, par value, P100, issued, 50,000 shares The bottom part of the income statement of the business shows the following items: Income before extraordinary items and cumulative effect of a change in accounting principle Extraordinary gain, net income tax Income before cumulative effect of a change in accounting principle Cumulative effect of a change in accounting principle, net of tax Net income

P600,000 __75,000 P675,000 _(50,000) P625,000 ------------

The earnings per share figures for the company will be presented below the final net income as follows: Earnings per common shares: Income before extraordinary item and cumulative effect of a change in accounting principle Extraordinary gain Cumulative effect of a change in accounting principle Net income

P10.80 1.50 _(1.00) P11.30 ---------

The computations are: Income before extraordinary item Less preferred dividends (P1,000,000 x 6%) Income before extraordinary item applicable to common P600,000 __60,000 P540,000

------------

Earnings per share: Income before extraordinary item (P540,000 + 50,000 shares) Extraordinary item (P75,000 + 50,000 shares) Cumulative effect of change in accounting principle (P50,000 + 50,000 shares) Complex capital structure

P10.80 1.50

_(1.00) ---------

A company with a complex capital structure is required to present two earnings per share. This dual presentation consists of a primary earnings per share and a fully diluted earnings per share. The primary earnings per share may be designated in the income statement as earnings per common and common equivalent share and the fully diluted earnings per share may be designated as earnings per common share-assuming full dilution. The dual presentation of earnings per share is illustrated as follows: Earnings per common and common equivalent share: Income before extraordinary item Extraordinary item Net income Earnings per common share-assuming full dilution: Income before extraordinary item Extraordinary item Net income

Pxxx xxx Pxxx ------

Pxxx _xxx Pxxx -----The primary earnings per share is computed on the assumption that common stock equivalents are converted into or exchanged for common stock. The bases for computing primary earnings per share are thus the common stock outstanding and common stock equivalents that have a dilutive effect on earnings per share. The fully diluted earnings per share is based on the assumption that all contingent issuances which could reduce the earnings per share have taken place. The computation includes common stock outstanding, common stock equivalent, and other potentially dilutive securities not qualifying as common stock equivalents. The primary or fully diluted earnings per share is presented only if a dilution results. Dilution means a decrease in the earnings per share or an increase in the loss per share, which includes common stock equivalents, is P6.00, then there is no dilution because the primary earnings per share is higher than the earnings per share without the common stock equivalents.

The presentation of the primary of fully diluted earnings per share is not also made even when a dilution results if the dilution is not material. A dilution is material if the decrease in the earnings per share is at least three percent. For example, if the earnings per share without the dilutive securities is P5.00, and the earnings per share with the dilutive securities included is P4.90, no presentation of primary earnings is required because the dilution is only P.10, or 2 per cent (P.10 + P5.00), which is less than 3 per cent. In determining the materiality of the dilution, all dilutive securities are to be included in the computation. Common stock equivalents A common stock equivalent is a security or which is not in the form of a common stock but is in substance equivalent to common stock because of the terms or conditions of its issuance. The terms or conditions are such that the security or right can be converted into or exchanged for common stock, or can be exercised to acquire common stocks. The value of the common stock equivalent tends to change with the value of the common stock because of its common stock characteristics of features. Examples of common stock equivalents are: 1) Convertible securities 2) Options and Warrants 3) Two-class common stock and participating securities 4) Contingent shares A common stock equivalent is always a common stock equivalent if at the time it was issued it qualified as a common stock equivalent. However, a common stock equivalent is included in the computation of the primary earnings per share only if it is dilutive. A common stock equivalent may not always be dilutive. It may be dilutive in one year but not dilutive in another year. If it is dilutive, then it is included in the computation or presentation of the primary earnings per share. Convertible securities A convertible security is one which entitles the holder to convert or exchange the security for a common stock. A convertible security may be a convertible bond or a convertible preferred stock. A convertible security may or may not be a common stock equivalent. It is a common stock equivalent if at the time it was issued; its cash yield is less than 66 2/3% of the yield of a comparable security without conversion features. The security which is used as a basis for comparison is the average Aa corporate bond. An Aa corporate bond is one that is rated Aa by bond rating agencies and is a high quality bond. Thus, if the cash yield of a convertible security is less than two-thirds of the yield of an average Aa corporate bond, it is a common stock equivalent. This means that the security has sufficient common stock characteristics which make investors willing to accept a lower yield.

The cash yield of a security is the annual return on the security divided by its current market price. For example, if the annual interest on a bond with a face value of P100 is 10%, or P10 per year, and the current market price is P90, then the cash yield is 11.11% (O10 + P90). Consider the following convertible securities: 1) A 7% convertible bond is sold at 105. The Aa corporate bond yield is 12%. 2) An 8% convertible preferred stock, P100 par value, is sold at par. The Aa corporate bond yield is 12% 3) A 6% convertible bond is sold at 95. The Aa corporate bond yield is 9%. An evaluation of these securities as to whether they are common stock equivalents or not is made below. Security 1) 7% convertible bond 2) 8% Convertible pref. Stock 3) 6% Convertible bond Cash Yield _17_= 6.67% P105 _P8_= 8.00% P100 _P6_=6.32% P 95 66 2/3% of Aa Corp. Bond Yield 2/3 x 12 = 8%

2/3 x 12 = 8% 2/3 x 9 = 6%

The 7% bond is a common stock equivalent since its cash yield at the time issuance is less than two-thirds of the average Aa corporate bond yield. The 8% convertible preferred stock and the 6% convertible bond are not common stock equivalents since their yields are not less than two-thirds of the Aa corporate bond yield. In addition to the yield test for convertible securities, it is also required that a security must be convertible within a period of five years from the date of the financial statements before a convertible security will be included in the computation of the primary earnings per share. A convertible security which does not meet the yield test or which is convertible beyond five years but within ten years is not included in computing the primary earnings per share. It is, however, included in computing the fully diluted earnings per share if it is dilutive. The If Converted Method A convertible security which qualifies as a common stock equivalent is assumed to be converted into common stock using the if convertible method. A convertible security is assumed to be converted into common stock at the beginning of the period or at the time of its issuance, whichever is later. Since the convertible security is assumed to have been converted into common stock, there would be no interest expense ( in the case of bonds) or preferred dividends ( in the case of preferred stock) that would have been paid. In computing earnings per share, the

interest expense on bonds, net of tax, should therefore be added back to net income in arriving at the income application to common stock. Preferred dividends would not likewise be deducted from net income in computing the earnings per share. The assumed conversion of the security will also increase the number of shares to be used in computing the primary earnings per share. The if converted method for convertible securities is illustrated in the following examples: Example 1. The relevant data are given below.

6% convertible bond, sold at par Jan. 1, 19A P500, 000 Aa corporate bond yield 10% Conversion terms of bond 20shares for each p1, 000 bond number of common shares outstanding, Jan. 1, 19A (no change during the year) P100, 000 Net income for 19A P400, 000 Income tax rate 40% The earnings per shares without the convertible bond is: Actual net income Number of shares outstanding Earnings per share (P400, 000 100,000) P400, 000 100, 000 P4.00

The convertible bond is a common stock equivalent because its cash yield of 6% is less than twothirds of the Aa corporate bond yield of 10%. The convertible bond should therefore be considered in computing the primary earnings per share. The primary earnings per share is computed as follows: Actual net income Add: interest expense, net of tax (P500,000 x 6% x 6-%) Adjust net income Actual number of shares outstanding Add shares issued upon assumed conversion of bonds (P500,000 + P1,000 x 20 shares) Adjust number of shares Primary earnings per square (P418,000 110,000) P400, 000 18,000 P418, 000 100,000 10,000 110,000 P3.80__

Since the earnings per square with the convertible bond is lower than the earnings per share without the convertible bond, and the dilution is material (P.20 P4.00 = 5%), the earnings per share to be reported in the income statement would be P3.80. Example 2. Assume in the above example that the bonds have an interest rate of 15% instead of 6%. All other facts remain the same. The primary earnings per share would be: Actual net income Add: interest expense, net of tax P400, 000

(500,000 x 15% x 60%) Adjust net income

45,000 P445, 000

Adjusted number of shares (same as above) 110,000 Primary earnings per square (P445, 000 / 110,000) P4.04 Since the primary earnings per share is higher than the bond earnings per share without the convertible bond, the convertible bond is antidilutive. The primary earnings per share would not therefore be reported in the income statement. The earnings per share to be reported would be P4.00, the earning per share without the convertible bond. A convertible bond is antidilutive when the interest expense, net of tax, divided by the number of shares assumed to be issued on the conversion of bonds exceeds the earnings per share without the convertible bond. In the given example, the interest expense (net of tax) per share is P4.50 (P45, 000 10,000), which is higher than P4.00. Example 3. Assume in the first example that the bonds were issued only on April 1, 19A instead of January 1, 19A. All other facts remain unchanged. In this case, conversion is assumed to have occurred on April 1, 19A since this is later than the beginning of the year. The computation of the primary earnings per share would be: Actual net income Add: interest expense, net of tax (P500,000 x 5% x year x 60%) Adjusted net income Actual shares outstanding Add shares issued upon assumed conversion of bonds (P500,000 P1,000 x 20 = 10,000 x 3/4) Adjusted number of shares Primary earnings per share (P413, 500 107,500) P400, 000 13,500 P413, 500 100,000 7,500 107,500 P3.85

The related interest, net of tax, that was added back to net income is the amount of interest for the period April 1 to December 31. The shares assumed to be issued on April 1 are also outstanding only for nine months (April 1 December 31). Example 4. Using the same facts of the first example, assume that the bonds of P500, 000 issued on Jan. 1, 19A were actually converted on May 1, 19A and that the actual net income for 19A was P412, 000 rather than P400, 000. When actual conversion takes place, it is still necessary to assume conversion for the portion of the year that the convertible bonds were outstanding. The earnings per share with the converted bonds is: Actual net income Actual number of shares outstanding: Jan. 1 Dec. 31 100,000 x 12/12 P412,000 100,000

May 1 Dec. 31 10,000 x 8/12 Average shares outstanding

6,667 106,667

Earnings per share (P412, 000 106,667) P3.86 The earnings per share assuming conversion took place at the beginning of the year is: Actual net income Add: interest expense, net of tax (P500, 000 x 6% x 4/12 x 60%) Adjusted net income Actual number of shares outstanding Jan. 1 Dec. 31 100,000 x 12/12 May 1 Dec. 31 10,000 x 8/12 Shares issued upon assumed conversion of bonds (P500, 000 P1, 000 x 20 = 10,000 x 4/12) Adjusted number of shares Primary earnings per share (P418, 000 110,000) P412, 000 6,000 P418, 000

100,000 6,667 3,333 110,000 P3.80

The dilution in the earnings per share is only 1.55% (P.06 P3.86), which is not material. However, since actual conversion took place, the earnings per share of P3.80 would still be reported on the income statement. Example 5. Assume in the first example that instead of the convertible bond being issued on Jan. 1, 19A, 5,000 shares of 6% convertible preferred stock , P100 per value, were issued at par. Assume further that each share of preferred stock is convertible into four shares of common stock. The convertible preferred stock is a common stock equivalent as its yield of 6% is lesser than 6.67%, or two-thirds of the Aa corporate bond yield of 10%. The earnings per share without the preferred stock is: Net income Less preferred dividends (P500,000 x 6%) Income applicable to common Dividend by average number of shares outstanding Earnings per share P400, 000 30,000 P370, 000 100,000 P3.70

Since the preferred stock is, however, a common stock equivalent, it would be necessary to compute a primary earnings per share. The primary earnings per share is: Net income P400, 000 Actual number of shares outstanding Shared issued upon assumed conversion of preferred stock (5,000 shares x 4) Adjusted number of shares Primary earnings per share (P400, 000 120,000) 100,000 20,000 120,000 P3.33

-----The preferred dividends were not subtracted from net income as the preferred stock is assumed to have been converted into common stock at the beginning of the year. The preferred stock is a dilutive security since it decreased the earnings per share from P3.70 to P3.33. As a general rule, a convertible preferred stock is dilutive if the dividends per share based on the number of shares assumed to be issued upon conversion is lower than the earnings per share computed without the preferred stock. In the above example, the dividends per share is P1.50 (P6 annual dividend per share 4 common shares), which is lower than the earnings per share of P3.70 without the preferred stock conversion. Options and warrants Options and warrants are rights which entitle the holder to acquire common stock up in the payment of a specified price. For purposes of computing earnings per share, stock purchase contracts, stock subscriptions not fully paid, deferred compensation plans providing for the issuance of common stock, and convertible debt or preferred stock allowing or requiring the payment of cash at conversion regardless of the yield of these securities at the time of issuance are considered as equivalents of options and warrants. Options and warrants are always considered as common stock equivalents. However, when the exercise price is higher than the current market price, the holders of options or warrants would not exercise their rights to acquire common stock since they could acquire the same stock at a lower price in the market. In this case, there would be no potential dilution from the options or warrants. Exercise is thus assumed only when the average market price is higher than the exercise price per share of common stock. The average market price is the average price for substantially all of three consecutive months, including the last month of the period of which earnings per share data being computed. Options and warrants are included in the computation of primary earnings per share if they are dilutive (market price is greater than exercise price) and exercise will take place within five years. Treasury stock method Options and warrants which are dilutive are accounted for under the treasury stock method. An option or warrant is assumed to have been exercised at the beginning of the period or at the time it was issued, whichever is later. The exercise of the option or warrant results in an increase in the number of shares outstanding due to the issuance of additional shares. The proceeds from holders of options or warrants who exercise their rights, however, are assumed to be applied to the repurchase of outstanding shares of common stock. The outstanding shares are assumed to be repurchased at the average market price of the common stock during the period. The number of shares will thus increase by the difference between the number of shares assumed to be issued and the number of shares assumed to be repurchased. This net increase in the number of shares that results from the application of the treasury stock method is referred to as the incremental shares.

The exercise of an option or warrant does not have any effect on the net income to be used in computing the earnings per share.

The treasury stock method for computing the incremental shares is illustrated below. Common shares outstanding during the entire year Options outstanding during the year Exercise price per share of common stock Average market price of common stock Net income for the year The earnings per share without the option is: Net income Actual number of shares outstanding Earnings per share (P75, 000 50,000) P75, 000 50,000 P1.50 50,000 5,000 P4 5 P75, 000

The average market price of the option is higher than the exercise price. Hence, exercise of the option is assumed to be made. The computation of primary earnings per share is shown below. Actual number of shares outstanding Add incremental shares: Shares issued on assumed exercise of options 5,000 Less assumed repurchase of shares from proceeds of options (5,000 shares x P4 = P20,000 P5) 4,000 Adjusted number of shares Primary earnings per share (P75, 000 51,000) 50,000

1,000 51,000 P1.47

The option has a dilutive effect on the earnings per share but the dilution is not material, the dilution being only 2% (P.03 P1.50). Hence, the earnings per share of P1.47 would not be reported in the income statement. Modified treasury stock method When the number of shares assumed to be repurchased from the proceeds of options or warrants exceeds 20% of the actual number of shares outstanding at the end of the period, a modification of the treasury stock method is necessary. The proceeds from the assumed exercise of options or warrants are to be applied as follows: 1) The proceeds are first applied to the repurchase of outstanding common shares not to exceed 20% of the total shares outstanding; 2) The balance, if any, are to be applied to the reduction of outstanding short-term or long-term debt;

3) If outstanding debts have been paid and a balance still remains, any remaining balance is to be invested in interest-yielding short-term government securities or commercial paper. A limitation of 20% on the repurchase of outstanding shares is imposed since a large repurchase would materially affect the price of the stock. To illustrate, assume the following data: Common shares outstanding Options outstanding Exercise price Average market price of stock 10% Bonds payable Net income for the year Income tax rate 8,000 4,000 P3 P4 P20, 000 P30,000 40%

The maximum number of shares that could be repurchased is 1,600 shares, or 20% of 8,000 shares. The earnings per share without option is: Actual net income Actual number of shares outstanding Earnings per share (P30,000 8,000) The primary earnings per share is computed as follows: Proceeds from assumed exercise of options (4,000 x P3) Less proceeds applied to repurchase of outstanding shares 8,000 x 20% x P4 Balance applied to retirement of bonds Actual net income Add: Interest, net of tax (P5, 600 x 10% x 60%) Adjusted net income Actual number of shares outstanding Add incremental shares: On assumed exercise of options Less assumed repurchase of shares Adjusted number of shares Primary earnings per share (P30, 336 10,400) Contingent shares Contingent shares are those which are to be issued upon the occurrence of certain conditions. Examples of conditions are: 1) The passage of time along with other conditions. 2) The maintenance of some levels of earnings P12, 000 6,400 P5, 600 P30, 000 336 P30, 336 8,000 4,000 1,600

P30, 000 8,000 P3.75

2,400 10,400 P2.92

3) The attainment of some levels of earnings 4) Changes in the market prices which modify the number of shares to be issued If shares are to be issued upon the mere passage of time, such shares are treated as common stock equivalents and included in computing the primary earnings per share. If shares are to be issued upon the maintenance or attainment of some levels of earnings, and these conditions are met, the additional shares shall be considered as outstanding for purposes of computing the primary and fully diluted earnings per share. If the attainment of some levels of earnings is not being currently met, the additional shares shall be considered only in computing the fully diluted earnings per share, but only if such shares are dilutive. Fully diluted earnings per share Fully diluted earnings per share are computed to show the maximum potential dilution in the earnings per share. The computation includes all potentially dilutive, securities such as convertible securities, options, warrants, and contingent issuances whether these are common stock equivalents or not. The fully diluted earnings per share, however, will be presented only if the dilution in the primary earnings per share is at least 3 per cent. Procedures for computing the fully diluted earnings per share follow the same procedures employed in computing the primary earnings per share. Convertible securities, options, and warrants are assumed to be converted or exercised at the beginning of the period or at the time of issuance, if later. However, there is one difference in the case of options or warrants. When the ending market price of the option or warrant is higher than the average price during the period, the market price at the end of the period is employed in the repurchase of outstanding shares from the proceeds of options or warrants. The purpose of using the higher market price at the end of the period is to show the maximum potential dilution in the earnings per share. Illustration-fully diluted earnings per share To illustrate the computation of fully diluted earnings per share, consider the following capital structure: 10-year, 7% convertible bonds 15-year, 9% convertible bonds Common shares outstanding (no change during year) Options outstanding during year Income tax rate Additional information: 1) The 10-year, 7% bonds were issued on January 1, 19A at face value. It is convertible into 80 shares of common stock for each P1, 000 bond. The 15-year, 9% bonds were issued on April 1, 19A at face value and are convertible into common stock at the rate of 100 shares for every P1, 000 bond. The average Aa corporate bond yield at the time the bonds were issued was 12%. P400, 000 P600, 000 100, 000 P300, 000 40%

2) The option were outstanding during the entire year. The exercise price per share of common stock on the options is P4.00. the average price per share of common stock during the year was P8. At the end of the year, the market price of the common stock was P10.00 per share. The primary earnings per share is first computed. The computation of the primary earnings per share is based on the common stock, the 10-year, 7% bonds which are common stock equivalents, and the options, which are also assumed to have been exercised since the average market price is higher than the exercise price. The 15-year, 9% bonds are not common stock equivalents since their yield of 9% is greater than 8%, or two-thirds of 12 per cent. Hence, the 15 year bonds are not included in computing the primary earnings per share. The computation of the primary earnings per share is given below. Actual net income Add: Interest, net of tax (P400, 000 x 7% x 60% ) Adjust net income Actual shares outstanding Shares issued on assumed conversion of 7% bonds (P400, 000 P1, 000 x 80) Shares issued on assumed exercise of options Shares issued on assumed to be repurchased from proceeds Of options (10, 000 x P4 8) Adjusted number of shares Primary earnings per share (P316, 800 137, 000) P300, 000 16, 000 P316, 800 P100, 000 32, 000 10, 000 (5, 000) 137, 000 P2.13

The earnings per share without the common stock equivalents is P3.00 per share, obtained by dividing the net income of P300, 000 by the number of shares outstanding of 100, 000. Since the primary earnings per share decreased by more than 3 per cent, the common stock equivalents are dilutive. The fully diluted earnings per share is computed as follows: Actual net income Add: interest on 7% bonds, net of tax (P400, 000 x 7% x 60% ) Interest on 9% bonds, net of tax (P600, 000 x 9% x 9/12 x 60%) Adjust net income Actual shares outstanding Shares issued on assumed conversion of 7% bonds (P400, 000 P1, 000 x 80) Shares issued on assumed conversion of 9% bonds (P600, 000 P1, 000 x 100 x 9/12) Shares issued on assumed exercise of options Shares assumed to be repurchased from proceeds of options (10, 000 x P4 P10) Adjusted number of shares P300, 000 16, 800 24, 300 P341, 100 100, 000 32, 000 45, 000 10, 000 (4, 000) 183, 000

Fully diluted earnings per share (P341, 100 183, 000)

P1.86

The computation of the fully diluted earnings per share includes the 15 year, 9% convertible bonds which did not qualify as a common stock equivalent. Since the bonds were issued only on April 1, 19A, they are assumed to have been converted only from that date. Hence, the adjustments to net income for the interest and to the actual number of shares for the additional shares should shares should only be for nine months. The market price of the common stock at the end of the year was used in computing the number of shares assumed to be repurchased since the ending market price was higher than the average price for the period. The fully diluted earnings per share is lower than that of the primary earnings per share. Hence, it would be reported in the income statement together with the primary earnings per share. Book value per share Book value per share is the equity of each share of stock in the assets of a company. It is the amount that each share of stock will receive from the company in the event of liquidation assuming that assets are sold at their book values. When there is only one class of stock of stock, the book value per share is computed by dividing the total stockholders equity by the number of common shares outstanding. When there are two classes of stock. Book values are computed by dividing the equity applicable to the two classes of stock by the number of shares of the class outstanding. The stockholders; equity is apportioned to the two classes of stock on the basis of the amount each class of stock is entitled to receive in case of liquidation. For the preferred stock, the relevant values to be considered are: 1) Liquidation value. This is the amount a preferred stockholder will receive if the company were liquidated. It is stated as an amount per share, which is not necessarily equal to the per value. 2) Cumulative dividends in arrears. If the preferred stock is cumulative, dividends for past periods which have not been paid, referred to as dividends in arrears, must be added to the liquidation value in computing the equity applicable to the preferred stock. 3) Participating feature. Preferred stock which have participating features are entitled to receive dividends over and beyond a fixed rate. These additional dividends should likewise be added to the equity of preferred stockholders. The equity of the common stockholders is a residential equity. It is the equity that remains after subtracting the equity of the preferred stockholders from the total stockholders equity. The computations of book values are illustrated in the cases below. The computations are based on the stockholders equity of the White Flower Co. on December 31, 19A, which appears as follows: 6% Preferred stock, par and liquidating value, P100; issued, 10, 000 shares

P1, 000, 000

Common stock, par value, P100; issued, 5, 000 shares Retained earnings Total stockholders equity Preferred stock is noncumulative, nonparticipating

500, 000 300, 000 P1, 800, 000

Assume that the preferred stock is noncumulative and nonparticipating. Book values for the White Flower Co. on Dec. 31, 19A are calculated as follows: Total stockholders equity Less equity applicable for preferred: Liquidation value, 10, 000 shares @ P100 Dividends in arrears, P1, 000, 000 x 6% x 3 years Equity applicable to common Book values per share: Preferred - P1, 180, 000 10, 000 shares Common P620, 000 5, 000 shares P1, 800, 000

P1, 000, 000 180, 000 P 1, 180, 000 620, 000

P118.00 124.00

When preferred stock is cumulative and dividends are in arrears, retained earnings equal to the dividends in arrears are allocated to preferred stock. The balance of retained earnings is allotted to common stock.

Preferred stock is cumulative and fully participating Assume that the preferred stock is cumulative and fully participating with common stock after common stock has been paid the preferred rate. Dividends during the current year have been declared. Book values per share are computed as follows: Total stockholders equity Less equity applicable to preferred: Liquidation value, 10,000 shares At P100 Current dividends and retained Earnings in participation With common (see below) Equity applicable to common 1, 180, 000

P1, 000, 000

200, 000

1, 200, 000 P 600, 000

Distribution of retained earnings: Preferred Current dividends: Preferred P1, 000, 000 x 6% Common-P500, 000 x 6% Balance distributed ratably: Preferred P1, 000, 000 x P210, 000 P1, 500, 000 Common P500, 000 x P210, 000 P1, 500, 000 Total Book values per share: Preferred P1, 200, 00010, 000 shares Common P600, 0005, 000 shares P60, 000 P30, 000 140, 000 70, 000 P200, 000 P100, 000 210, 000 P300, 000 P90, 000 Common Total

P120.00 P120.00

When preferred stock is cumulative and fully participating and dividends are in arrears, retained earnings equal to the dividends in arrears are allotted to the preferred stock, any balance of retained earnings is distributed ratably to preferred and common. When current dividends have not been declared, retained earnings equal to the current dividends are allotted to the preferred stock and common stock, any balance of retained earnings is allocated pro rata to preferred and common stock. QUESTIONS: 1. What is earnings per share? What is its significance? 2. Define book value per share. Discuss its significance. 3. Distinguish a company with a simple capital structure from one with complex capital structure. 4. What are current equivalent shares? 5. What is the reason for giving retroactive recognition to stock dividends and stock splits in the computation of earnings per share? 6. What is the purpose of presenting several earnings per share figures in the income statement instead of a single earnings per share? 7. What presentation of earnings per share is required of a company with a complex capital structure? 8. What securities are to be included in computing (a) primary earnings per share and (b) fully diluted earnings per share? 9. What are common stock equivalents? Give examples.

10. (a) what conditions must be met in order that a convertible security may be regarded as a common stock equivalent? (b) what conditions must be met in order that an option or warrant may be regarded as a common stock equivalent? 11. What concept governs the treatment of securities such as convertible securities and options and warrants as common stock equivalents? 12. Explain the if converted method for convertible securities. 13. Discuss the treasury stock method for options and warrants. 14. How is a security that does not qualify as a common stock equivalent treated in the computation of earnings per share? 15. What is the purpose of presenting a fully diluted earnings per share? 16. When is a security regarded as (a) dilutive and (b) antidilutive? 17. What is the treatment of a security that is found to be antidilutive? 18. What is the rule of materiality that is employed in connection with earnings per share computations? EXERCISES: 1. The following transactions relating to the common stock of the Serrano Co. Jan. March July Aug. Sept. Dec. 1 31 1 30 30 1 Balance: 40,000 shares Issued 3,000 shares Issued 5,000 shares Issued a 25% stock dividend Issued a 2-for-1 stock split Required 12,000 shares of common stock Compute the weighted average number of shares outstanding.

Required:

2. The liabilities and stockholders equity section of the balance sheet of Reyes Company on December 31, Year 6 included the following: 9% Convertible bonds Preferred stock, P25 par, convertible. issued and outstanding, 5,000 shares Common stock, P10 par, issued and outstanding, 30,000 shares P250,000 125,000 300,000

The convertible bonds were issued on July 1, Year 6 and are convertible into 30,000 shares of common stock. The bonds do not qualify as common stock equivalents. The preferred stock is convertible into common stock at the rate of one share of common for every share of preferred. The preferred stock has been outstanding during the entire year and is a common stock equivalent. On September 1, Year 6, 5,000 shares of common stock were issued.

Required: Compute the weighted average number of shares to be used in computing (a) the primary earnings per share, and (b) the fully diluted earnings per share.

3. The following information is provided by the Domingo Corporation on December 31, Year 4: Net income before income taxes and extraordinary item Income taxes expense Income before extraordinary item Extraordinary loss, net of tax of P7,000 Net income P100,000 40,000 P 60,000 20,000 P 40,000 ----------P100,000 250,000

7% preferred stock, P100 par Common stock, P10 par

Required: Compute the earnings per share under each of the following consumptions: (1) The preferred stock is nonconvertible and noncumulative. No dividends per paid or declared during the year. (2) The preferred stock is nonconvertible and cumulative. No dividends were paid or declared. 4. Data related to the income statement and balance sheet of the Ventura Corporation for the year ended and as of December 31, Year 5 follow: Income statement data: Income before extraordinary item and cumulative effect of change in accounting principle Extraordinary item-gain on extinguishment of long-term debt (less applicable income taxes of P22,500) Cumulative effect of a change in accounting principle (less applicable income tax of P9,000) Net income Balance sheet data: 10% Cumulative preferred stock Common stock, P50 par Additional information: (1) The preferred stock is not convertible into common stock. P300,000 500,000

P180,000 75,000 (30,000) P225,000 ------------

(2) On January 1, Year 5, there were 6,000 common shares outstanding. On April 1, 2000 shares of common stock were sold at par, and on December 31, a 25% stock dividend was issued. Required: Show how the primary and fully diluted earnings per share would be reported by Ventura Corporation in its income statement for the year ended December 31, Year 5. 5. Information relative to various securities is given below. (a) (b) (c) (d) (e) (f) (g) (h) (i) A 5% nonconvertible bond sold at its par value of P100. The average Aa corporate bond yield at time of issuance was 9%. A convertible 6% preferred stock, par value, P100, sold at par. The average Aa corporate bond yield at time of issue was 12%. A convertible, 12% bond sold at face value. The average Aa corporate bond yield at time of issue was 18%. A convertible, 9% bond, sold at 96. The average Aa corporate bond yield at time of issue was 14%. A convertible, 8% bond, sold at 105. The average Aa corporate yield at time of issue was 12%. Options to acquire 1,000 shares of common stock at P4 per share. The average market price per share of common stock was P5 per share. Warrants to acquire 2,000 shares of common stock at P10 per share. The average market price of common stock was P8 per share. An agreement was made with management to issue 10,000 shares of common stock if a 10% increase in income will be reported for the following year. An agreement was entered into whereby management is obligated to issue 20,000 shares of common stock one year from today at a price equal to the prevailing market price at that date.

Required: Determine whether each of the securities described above qualities as a common stock equivalent. State the reason for each answer. 6. Determine for each of the following cases whether the common stock equivalent is dilutive or antidilutive. Assume that the simple earnings per share (without the common stock equivalent) is P4.00, and the income tax rate to be 40%. (a) Options to acquire common stock at P25 per share. The average market of the common stock during the year was P20. (b) A 14% convertible preferred stock, par value, P50. Each share of preferred stock is convertible into two shares of common stock. (c) A P9 convertible preferred stock, par value, P100. Each share of preferred stock is convertible into two shares of common stock. (d) A P500,000, 9% convertible bond. Each P1,000 bond is convertible into 20 shares of common stock. (e) A P600,000, 12% convertible bond. Each P1,000 bond is convertible into 15 shares of common stock.

7. The Rimando Companys balance sheet December 31, Year 8 contained the following information: 12% Nonconvertible bonds P 800,000 Convertible, 10% Preferred stock, P100 par 1,000,000 Nonconvertible, 12% Preferred stock, P25 par 1,250,000 Common stock, P50 par Additional paid-in capital Retained earnings P2,875, 000 1,250, 000 1,600, 000

The convertible preferred stock is dilutive common stock equivalent. Each share of preferred stock is convertible into four shares of common stock. The rimando company paid the regular cash dividends on the preferred stock and issued a 15% stock dividend on common stock during the year. The net income during the year was P382, 500. Required: Compute the earnings per share of the Rimando co. for year 9.

8. On December 31, 19D,the Olivia Company had 200,000 shares of common stock outstanding. Olivia Company had P500, 000 of 8% convertible bonds outstanding throughout 19D which are common stock equivalents. On October 1, 19E, Olivia Co. issued 9% convertiblebonds with a face value of P800, 000. The 9% bonds did not qualify as common stock equivalents at the time of their issuance. The 8% and 9% bonds are convertible into common stock at the rate of 40 shares for each P1, 000 bond. The net income of the Olivia Company for the year ended December 31, 19E was P875,000. The income tax rate for 19E was 40% Required: Compute the primary and fully diluted earnings per share of the Olivia Co. for the year ended December 31, 19E. 9. On December 31, 19A the Morena Co. had 150,000 shares of common stock outstanding. In addition, the company had P400,000, convertible into 20,000 shares of common stock and are dilutive common stock equivalents. On June 1, 19B, the company issued 30, 000 additional shares of common stock. On September 30, 19B, all the bonds were converted into common stock. The net income of the Moreno Co. for the year ended December 31, 19B was P649,200. The income tax rate was 40%

Required:

Compute the primary earnings per share of the Moreno Co. for the year ended December 31, 19B.

10. Superior Metalcraft Co.s capital structure on December 31, year 4 appeared as follows: Common stock, P25 par P250,000 Premium on common stock 50,000 Retained earnings 100,000

Stock options to purchase 4,000 shares of common stock at P35 per share were also outstanding throughout the entire year. The average market price of the stock during the year was P40 and the market price on December 31, Year 4 was P50. The net income of the company for the year ended December 31, Year 4 was P60,000. Required: Compute the primary and fully diluted earnings per share of the Superior Metalcraft Co. for the year ended December 31, Year 4. 11. The stockholders equity section of the Buendia Company on Dcember 31, 19A consist of the following: Common stock, P50 par value, authorized, 50,000 shares, issued, 20,000 shares P1,000,000 Common stock subscribed 250,000 Additional paid-in capital 100,000 Retained earnings 600,000 Treasury stock, 5,000 shares at cost 300,000 Required: Calculate the book value per share of common stock outstanding. 12. The stockholders equity section of the Lorelei Companys balance sheet as of December 31, 19D was as follows: 10% Preferred stock, P100 par value, Authorized, 10,000 shares, issued And outstanding, 5,000 shares Common stock, P10 par value, authorized 100,000 shares, issued and outstanding, 80,000 shares Additional paid-in capital Retained earnings Total stockholders equity

P 500,000

800,000 300,000 400,000 P2,000,000 -------------Required: Compute the book values per share of preferred stock and common stock assuming: (a) Preferred stock is noncumulative and nonparticipating. The liquidation value of preferred stock is equal to par value. (b) Preferred stock is cumulative and nonparticipating and dividends are in arrears for three years (including the current year). The liquidation value of preferred stock is P105. 13. The Par Co. Had 300,000 shares of common stock issued and outstanding at December 31, 19A. No common stock was issued during 19B. On January 1, 19B, Par issued 200,000 shares of nonconvertible preferred stock. During 19B Par declared and paid P150,000 cash dividends on the common stock and P120,000 on the preferred stock. Net income for the year ended December 31,19B was P660,000. What should be Pars 19B earnings per common share? a. P1.30 b. P1.70

c. P1.80 d. P2.20 AICPA 14. At December 31, 19B and 19A, growth Corp. Had 100,000 shares of common stock and 10,000 shares of 5%, P100 par value cumulative preferred stock outstanding. No dividends were declared on either the preferred or common stock in 19B or 19A. Net income for 19B was P1,000,000. For 10B, earnings per common share amounted to a. P10.00 b. P9.50 c. P9.00 d. P5.00 AICPA 15. Randy, Inc. Had 20,000 shares of common stock outstanding at Jan. 1, 191. On may 1,19A, it issued 10,500 shares of common stock. Outstanding all year were 10,000 shares of nonconvertible preferred stock on which a dividend of P4 per share was paid in December, 19A. Net income for 19A was P96,700. Randys earnings per share for 19A are a. P1.86 b. P2.10 c. P2.84 d. P3.58 AICPA 16. On December 31, 19A, Charisma, Inc. Had 300,000 shares of common stock issued and outstanding. Charisma issued a 10% stock dividend on July 1, 19B. On October 1, 19B, Charisma purchased 24,000 shares of its common stock for treasury, and recorded the purchase by the cost method. What is the number of shares that should be used in computing the earnings for share for the year ended December 31, 19B? a. 306,000 b. 309,000 c. 324,000 d. 330,000 AICPA 17. Peran Co. Had 200,000 shares of common stock issued and outstanding at December 31, 19A. No common stock was issued during 19B. On January 1, 19B, Peran issued 50,000 shares of convertible preferred stock. This stock is convertible into 100,000 shares of common stock, and is not considered a common stock equivalent. During 19B, Peran paid P300,00 cash dividends on the preferred stock. Net income for the year ended December 31, 19B was P750,000. What should be Perans primary earnings per share for 19B? a. P1.50 b. P2.25 c. P2.50

d. P3.75 AICPA 18. Manny, Inc. Had 300,000 shares of common stock issued and outstanding at December 31, 19A. On July 1, 19B, an additional 50,000 shares of common stock were issued for cash. Manny also had unexpected stock options to purchase 40,000 shares of common stock at P15 per share outstanding at the beginning and end of 19B. The average market price of Mannys common stock was P20 during 19B. What is the number of shares that should be used in computing primary earnings per share for the year ended December 31, 19B? a. 325,000 b. 335,000 c. 360,000 d. 365,000 AICPA 19. Information relating to the capital structure of Paramount Corporation is as follows: December 31 19A 19B Outstanding shares of: Common stock 90,000 90,000 Preferred stock, convertible into 30,000 shares of common 30,000 30,000 10% convertible bonds, convertible into 20,000 shares of common P 1,000,000 P 1,000,000 During 19B, Paramount paid P45,000 dividends on the preferred stock, which is considered a common stock equivalent. The convertible bonds are not common stock equivalents. Paramounts net income for 19B was P980,000 and the income tax rate was 40% 1. For the year ended December 31, !9B, the primary earnings per share is a. P10.89 b. P10.39 c. P8.17 d. P7.79 2. For the year ended December 31, 19B, the fully diluted earnings per share is a. P9.82 b. P8.29 c. P7.71 d. P7.43 AICPA 20. At December 31, 19A, Lex Inc. Had 600,000 shares of common stock outstanding. On April 1, 19B, an additional 180,000 shares of common stock were issued for cash. Lex also had P5,000,000 of 8% convertible bonds outstanding at December 31, 19B, which are convetible into 150,000 shares of common stock. The bonds were considered common stock equivalents

at the time of issuance and are dilutive in the 19B earnings per share computation. No bonds were issued on converted into common stock during 19B. What is the number of shares that should be used in computing primary earnings per share for 19B? a. 735,000 b. 780,000 c. 885,000 d. 930,000 AICPA 21. Newsounds Corporation had earnings per share of P12.00 for 19A, before taking any dilutive securities into consideration. No conversion or exercise of dilutive securities took place in 19A. However, possible conversion of convertible preferred stock, a common stock equivalent, would have reduced earnings per share to P11.90. The effect of possible exercise of common stock warrants would have reduced earnings per share by an additional P0.05. For 19A, what is the maximum amount that Newsounds may report as a single presentation of earnings per share? a. P12.00 b. P11.95 c. P11.90 d. P11.85 AICPA 22. Florante, Inc. Was organized on January 2, 19A, with the following capital structure: 10% cumulative preferred stock, par value P100 and liquidation value P105; authorized, issued, and outstanding 1,000 shares Common stock, par value P25; authorized 100,000 shares; issued and outstanding 10,000 shares

P100,000

P250,000

Florantes net income for the year ended December 31, 91A was P450,000, but no dividends were declared. 1. How much was Florantes book value per preferred share at December 31, 19A? a. P100 b. P105 c. P110 d. P115 2. How much was Florantes book value per common share at December 31, 19A? a. P45.00 b. P68.50 c. P69.50 d. P70.00 AICPA

PROBLEMS 4.1 Fajela Co. Had the following transactions involving its common stock during 19C and 19D: 19C Jan. 1 Balance: 10,000 shares of common stock with stated value of P20 per share April 30 Issued a 15% stock dividend Oct. 1 Issued 2,000 shares of common stock at P22 Nov. 30 Split its common stock on a 2-for-1 basis 19D June Aug. Sept. Nov. Dec.

30 30 30 1 1

Sold 3,000 shares of common stock at P23 Reacquired 2,000 shares of common stock Split common stock on a 3-for01 basis Sold 3,000 shares of treasury stock for P25 Retired 3,000 shares of treasury stock

Required: Compute the weighted average number of equivalent common shares for 19C and 19D. 4.2 The Farol Co. Reported the following balances and transactions relating to its stockholders equity accounts during 19A and 19B:

19A Jan. May Nov. Dec.

1 Balances: 10,000 shares of 8% cumulative preferred stock, par value P25 per share; 50,000 shares of common stock par value P10 per share; Retained earnings, P360,000. 1 Sold 6,000 shares of common stock for P12 per share 1 Issued a 10% stock dividend on common stock. The market price of the common stock was P14 per share. 31 Reported a net income of P125,000 during the year. 31 Paid 8% cash dividend on the preferred stock.

19B March July Sept. Nov. Dec. Required: (1) (2) (3) (4)

1 Sold 2,000 shares of preferred stock at par 1 Split common stock on a 2-for-1 basis 1 Purchased 12,000 shares of common stock at P6 per share to be held as treasury stock. 1 Sold 3,000 shares of treasury stock for P8.00 per share 31 Reporting a net loss of P48,000 for 19B. Compute the following for 19A and 19B: Weighted average of equivalent common shares Earnings per common share Book value per share of preferred stock. Book value per share of common stock.

4.3 The stockholders equity section of the balance sheet of the Santa Maria Corporation on December 31, 19A appeared as follows:

Preferred stock, 6& cumulative and nonparticipating, P100 par value, a uthorized 50,000 shares, issued and outstanding, 10,000 shares

P1,000,000

Common stock, par value P100, authorized, 400,000 shares, issued and outstanding, 50,000 shares Retained earnings Total stockholders equity

5,000,000 2,000,000 P8,000,000 -------------

The following transaction affecting the stockholders equity of Santa Maria occurred during 19B and 19C:

19B April Oct. Dec.

1 Sold 40,000 shares of common stock at 105. 1 Repurchased 5,000 shares of common stock at 110 31 Paid cash dividends of 6% on preferred stock and issued a 25% stock dividends on common stock 31 The net income for 19C was P738,750 including an extraordinary loss (net of tax) of P61,875.

Required:

Compute the comparative earnings per share data for the Santa Maria Corporation.

4.4 The comparative income statements of the Silvestre Co. For the years ended December 31, Year 3 and Year 4 show the following:

Year 3 Income from continuing operations Discontinued operations: Income from operation of discontinued Division, net of tax of P27, 000 in Year 3 and P24, 000 in year 4 Loss on disposal of discontinued Division, net of tax of P12, 000 Income before extraordinary item an Cumulative effect of change in Accounting principle Extraordinary loss, net of tax of P16, 000 Cumulative effect of change in accounting Principle, net of tax of P6, 000 Net income P700, 000

Year 4 P750,000

63, 000 ________

56, 000 (28, 000)

P763, 000 (42, 000) _________ P721, 000 ________

P778, 000

14, 000 P792, 000 ________

The Silvestre Company had 120, 000 shares of common stock at the beginning of year 3. On June 1, year 3, the company issued 30, 000 shares of common stock. On November 1, year 4, the company issued a 20% stock dividend to its stockholder. Required: show how the earnings per share data of the Silvestre Company would be presented on the comparative income statement of the company for the years ended December 31, year 3 and year 4. 4.5 The following data for the Benjie Company are available in preparing a five-year summary of earnings per share to be included its annual report to stockholders. (1) The profits (losses) for the past five years were: 19A P300,000 19B P240,000 19C (150,000) 19D P380,000 19E P430,000 (2) On January 1, 19A, the company issued 10,000 shares of 6% cumulative, nonconvertible preferred stock, par value P10 per share, and 10,000 shares of common stock, par value P50 per share. (3) On December 31, 19A, the company issued a 20% stock dividend. (4) On April 1, 19C, the company issued 4,000 shares of common stock. (5) On December 31, 19C, the company effected a 4-for-1 stock split of its common stock. (6) On July 1, 19D, the company reacquired 6,000shares of common stock. (7) On September 30, 19E, the company recorded a prior-period adjustment due to an understand of depreciation of P12,000 for 19D. A claim for income tax refund of P4,000 had been failed. Required: Prepare a five-year summary of earnings per share data for the Benjie Co.

4.6 The Calderon Company had the following bonds to its balance sheet at the end of 19D: Face Amount (a) 10 year, 6% convertible bond, each P1,000 bond convertible into 40 shares (b) 15 year, 8% convertible Bond (c) 20-year, 10% convertible Date issued Issue price Aa Corp bond yield

P400,000

5/1//19C

100

9%

P600,000

1/1/19D

106

12%

bond, each P1,000 bond convertible into 50 shares

P800,000

1/1/19D

104

14%

(d) 20-year, 9% convertible bond, each P1,000 bond convertible into 60 shares

P500,000

9/1/19D

108

15%

Additional information: Actual number of common shares outstanding Net income for 19D Income tax rate Required: Compute the following earnings per share for 19D: (a) Primary earnings per share (b) Fully diluted earnings per share

70,000 P117,000 35%

4.7 The following data were taken from the balance sheet of the Gorospe Company at Decemberm31, 19F: 15-year, 14% convertible bonds 8% cumulative, convertible preferred stock, par value, P50 per share Common stock, par value, P10 per share P 500,000

1,500,000 3,000,000

Additional information: (1) The 15-year, 14% bonds were issued on January 1, 19F at 115 when the average Aa corporate bond yield was 19%. Each P1,000 bond is convertible onto 60 shares of common stock. (2) The preferred stock was issued on April 1, 19F at P55 per share. The average Aa corporate bond yield on the date of issue was 16%. Each share of preferred stock is convertible into 5shares of common stock were converted into common stock. (3) The net income after income taxes during the year was P585,000. The income tax rate was 35%. Required: Compute the earnings per share of Gorospe Company for 19F.

4.8 Selected information applicable to the Pearl Corporation is presented below. Net income P400,000 Common shares outstanding (no change during year) 30,000 6% Convertible bonds (common stock equivalent) P200,000 Conversion term of bonds 20 shares per P 1,000 bond Options outstanding during the year 5,000 Exercise price per share on options P18 Average market price per common share P20 Ending market price per common share P25 Income tax rate 40%

Required:

Compute the following earnings per share: (1) Primary earnings per share (2) Fully diluted earnings per share

4.9 The stockholders equity section of the Burnham Lake Co. on December 31, Year 7 showed the following balances: P7 Preferred stock, P50 par Common stock, P10 Paid-in capital Treasury stock, 10,000 shares at cost Additional information: (1) On January 1, Year 7, the company granted to its employees options to acquire 15,000 shares of common stock at P12 per share. The average market price during the year was P15. At the end of the year, the market price had risen to P20 per share. (2) On October 1, Year 7, all the options were exercised by the employees. The proceeds from the exercise of options were used acquire common stock at P18 per share. (3) On November 1, Year 7, the company issued 5,000 shares of convertible, cumulative preferred stock with 5,000 detachable stock warrants. Each warrant entitles the holder to acquire one share of common stock at P22 per share. No warrants were exercised during the year. (4) The net income during the year was P725,000. Dividends of P35,000 were paid on the preferred stock. Required: Compute the primary and fully diluted earnings per share. P250,000 900,000 300,000 180,000

4.10 The records of the Nicolas Co. on December 31, 19C show the following information: 10-year, 12% convertible bond s 20-year, 10% convertible bonds 6% Preferred stock, P100,000 par, cumulative, nonconvertible Common stock, P25 par Common stock warrants outstanding Net income for 19% Tax rate Additional information: (1) The 10-year, 12% convertible bonds are common stock equivalents. The 20-year, 10% convertible bonds are not common stock equivalents. Each P1,000 bond is convertible into 30 shares of common stock. No changes occurred in the bond balances during the year. (2) The common stock warrants entitle the holders to acquire common stock at P3 per share. The average market price of the common stock during the year was P5 per share. The market price at the end of the year was P6. No warrant was exercised during the year. P200,000 P300,000 P400,000 P600,000 5,000 P108,000 40%

(3) There were no sales or reacquisitions of stock during the year.

Required: From the above data, compute (a) the primary earnings per share and (b) the fully diluted earnings per share. 4.11 The Eugenio Company had the following stockholders equity on December 31, 19C: P8 Preferred stock, P50 par, authorized, issued, and outstanding, 5,000 shares Common stock, P25 par, authorized, 50,000 shares, issued and outstanding, 20,000 shares Additional paid-in capital Retained earnings Total stockholders equity

P250,000

500,000 75,000 P125,000 P950,000 ------------

Required: Compute the book value preferred stock and common stock December 31, 19C under each of the following assumptions: (a) Preferred stock is nonparticipating and cumulative. Preferred stock has a call value ofP55 per share and a liquidation value of P60 per share. (b) Preferred stock is nonparticipating and cumulative. All dividends have been paid on the preferred stock as of December 31, 19C. Preferred stock has a liquidation value of par. (c) Preferred stock is nonparticipating and cumulative with dividends in arrears for three years (including the current year) which must be paid regardless of the balance of Retained Earnings. The liquidation value of preferred stock is par. (d) Preferred stock is fully participating and noncumulative. Preferred stock has a liquidation value of par and is entitled to participate ratably with common in any distributions beyond stock par values. (e) Preferred stock is cumulative and fully participating, with dividends in arrears for two years (including the current year). The liquidation value of preferred stock is par. 4.12 Hulog Corporations capital structure is as follows: December 31 19B Outstanding shares of: Common stock Nonconvertible preferred stock 8% convertible bonds 336,000 10,000 P1,000,000 19A 300,000 10,000 P1,000,000

The following additional information is available: (1) On September 1, 19B, Hulog sold 60,000 additional shares of common stock

(2) Net income for the year ended December 31, 19B was P750,000 (3) During 19B, Hulog paid dividends of P3.00 per share on its nonconvertible preferred stock. (4) The 8% convertible bonds are convertible into 40 shares of common stock for each P1,000 bond, and were not considered common stock equivalents at the date of issuance. (5) Unexercised stock options to purchased 30,000 shares of common stock at P22.50 per share were outstanding at the beginning and end of 19B. The average market price of Hulogs common stock was P36 per share during 19B. The market price was P33 per share at December 31, 19B. (6) Warrants to purchase 20,000 shares of common stock at P38 per share were attached to the preferred stock at the time of issuance. The warrants, which expire on December 31, 19B, were outstanding at December 31, 19B. (7) Hulogs effective income tax rate was 40% for 19A and 19B. Required (show supporting computations in good form, and round earnings per share to the nearest centavo); 1. Compute the number of shares which should be used for the computation of primary earnings per common share for the year ended December 31, 19B. 2. Compute the primary earnings per common share for the year ended December 31, 19B. 3. Compute the number of shares which should be used for the computation of fully diluted earnings per common share for the year ended December 31, 19B. 4. Compute the fully diluted earnings per common share for the year ended December 31, 19B.

Chapter 5 Cost-Volume-Profit analysis Factors affecting profit Cost-volume-profit analysis, also called break-even analysis, is an analysis of the relationships of the factors affecting profit and the effect on profit of changes in these factors. The factors which affect profit are: 1. Sales price 2. Variable costs 3. Fixed costs 4. Sales volume 5. Sales mix The break-even chart The relationship of the factors which affect profit mat be shown in a break-even chart or graph. A standard break-even chart may be constructed as follows: 1) Plot the fixed costs line 2) Plot the variable costs on top of the fixed costs to obtain the total cost line 3) Plot the revenue line 4) Determine the break-even point To illustrate the construction of a break0even chart, assume the following data: Selling price per unit P4.00 Variable cost per unit 2.00 Total fixed costs P10,000.00 Sales at maximum capacity 10,000 units The break-even chart for the given data is shown on the following page. The horizontal axis of the break-even graph represents the volume and may be expressed in units of product, sales pesos or percentage of capacity. The vertical axis represents revenues and costs, which are stated in pesos. The fixed cost line is plotted as a horizontal axis and intersects the vertical axis at a point equal to the amount of fixed costs.

The variable costs are plotted on top of the fixed costs. The resulting line represents the total costs, which includes the fixed and variable costs. The equation of the total cost is equal to the fixed costs. This is the point on the vertical axis where the total cost line originates. At the maximum sales volume of 10000 units, the total cost is P30000, which consists of fixed costs of P10000 and variable costs of P20000.

Fig. 5.1 Break-even chart The total revenue line is a straight line which starts from the zero volume. The equation of the revenue line is: y = P4x, where y is the total revenue and x is the volume, in units of product. When volume is zero, and when volume is 10000 units, total revenue is P40000. When the horizontal axis is labelled in sales pesos, the total revenue line has the equation: y = x. The total revenue line is drawn such that the line is equidistant from the horizontal and vertical axis. The break-even chart shows the following information: (1) The break-even point, and (2) The profit or loss at any volume. The break-even point is the point where the total cost line and the total revenue line intersect. At this point, total revenue is equal to total cost. Alternatively, the break-even point is the point where there is no profit or loss. In Fig. 5.1, the break-even point is 5000 units.

The profit or loss at any volume can be determined from the break-even graph. At any volume above the break-even point, there is a profit; at any point below the break-even point, there is a profit; at any point, there is a loss. The profit or loss is measured by the vertical distance between the total revenue line and the total cost line. The profit or loss tends to increase as the business moves further away from the break-even point. Inverted graphic approach An alternative form of the break-even chart is shown below. The variable costs are plotted first on the graph then the fixed costs are plotted on top of the variable costs. The total cost line and the total revenue line, however, are not affected. The advantages of this alternative graph is that it shows more clearly the difference between the total revenue and the total variable costs at any volume. The difference between total revenues and total variable costs is called the contribution margin.

Fig. 5.2 Break-even chart

Assumption of cost-volume-profit analysis The construction of a break-even chart is relatively simple. However, there are several assumptions which underlie cost-volume-profit analysis. These assumptions need to be understood in order to better appreciate the uses and limitations of cost-volume-profit analysis.

The assumptions underlying cost-volume-profit analysis are: 1) All cost can be properly classified into variable and fixed costs. 2) The selling price per unit is constant at all volumes. 3) The variable cost per unit remains the same throughout all volume ranges. 4) The total fixed cost is constant at all volumes. 5) The prices of cost inputs remain unchanged. 6) Efficiency of employees and machines, production methods, and managerial policies are unchanged. 7) In the case of multiple products, the sales mix is assumed to be stable. 8) Sales and production are assumed to be equal. Cost-volume-profit analysis is based on the assumption that all costs are either fixed or variable. A valid analysis will therefore depend on the proper and accurate classification of costs into variable fixed costs. The selling price per unit, variable cost per unit, and total fixed costs are assumed to be constant at all volumes. When these assumptions do not hold, straight lines cannot be drawn to represent revenues and costs. The break-even chart is simply a representation of the relationships between revenues and costs at a given time. If changes in the revenues or costs occur because of changes in the prices of cost inputs, efficiency, production methods, managerial policies, etc., the relationships will change and the break-even chart will no longer be valid. A new break-even chart, however, can be constructed for the new set of relationships. When several products are sold, and the proportion in which these products are sold changes, the break-even chart will likewise become inapplicable in new situation. Lastly, when sales and production are not equal, the costs as well as the income computed under conventional accounting practice will not be the same as the income and costs computed under costvolume-profit analysis. In cases where sales and production are not equal, it is therefore necessary that adjustment be made to the accounting income or costs in order to determine the proper costs or income required for cost-volume-profit analysis. Relaxing the consumptions When the total revenue and costs are not linear functions of volume, it is possible that multiple break-even points can occur. For example, if selling price and unit variable costs are not constant but change over the volume range due, for example, to change in prices, rates, efficiency, or production vity, the revenue and cost lines will not be straight lines. The revenue line and the total cost line may be nonlinear, as shown in the figure on the following page. The break-even chart shows that the total cost and the total revenue lines intersect at two points. Thus, there are two break-even points. Algebraic approach The equation of the break-even point may be developed algebraically by defining the following symbols: y = total revenue or cost p = selling price per unit

v = variable cost per unit p v = unit contribution margin

Fig. 5.3 Break-even Chart TFC = total fixed cost x = volume, in units BEP = break-even point Using the above symbols, the equation of the total revenue and total cost can be obtained. The equation of the total revenue is y = px For the total cost, the equation is y = TFC + vx Since total revenue is equal to total cost at break-even point, we have px = TFC + vc px vx = TFC x(p v) = TFC x = TFC pv Thus, the equation of the break-even point is BEP (in units) = Total fixed costs___ Unit contribution margin Applying above formula to the example, we get

BEP = P10000 P2 = 5, 000 units

When the break-even point in pesos is desired to be obtained, it is simply derived by multiplying the break-even point in unite by the unit selling price. Thus, BEP (in pesos) = = = BEP, in unite x unit selling price 5, 000 units x P4 P20, 000

Where the break-even point in units is not available, the break-even point in pesos can be obtained directly by the following formula: BEP (in pesos) = _TFC_ 1 VC S

Where BEP = break-even point TFC = total fixed costs VC = variable costs S = sales VC = variable cost ratio S 1 VC = contribution margin ratio S The contribution margin ratio, also called the marginal income ratio, and P/V ratio, is the complement of the variable cost ratio. Hence, if the variable cost ratio is known, the contribution margin ratio can easily be determined. In words, the break-even point in pesos can be stated as follows: BEP (in pesos) = ___Total fixed costs____ Contribution margin ratio

Using the above formula to compute the break-even point in pesos, we get BEP (in pesos) = P10, 000 50% = P20, 000 The contribution margin ratio is: = 1 VC S = 1- P2 P4 = 50%

The break-even point expressed as a percentage of maximum capacity is given by the following formula: BEP(in % of capacity) = _______TFC__________ (p-v) x maximum capacity Where BEP = break-even point TFC = total fixed costs p-v = unit contribution margin Using the above formula, the break-even point for the given data is BEP (in % of capacity) = ____P10, 000___ (P4 P2) x 10, 000 50% Calculating profit at any volume The profit or loss at any volume can be obtained algebraically from the following formula: P Where P px vx TFC = = = = = px vx TFC profit total sales total variable costs total fixed costs

The profit, for example, at 6, 000 units based on the given facts, is calculated as follows: = P4 (6, 000) P2 (6, 000) P10, 000 = P2, 000 A cost-volume-profit income statement is presented below to show the income for 6, 000 units. P C-V-P Income Statement Sales Less variable costs Contribution margin Less fixed costs Net income P24, 000 12, 000 P12, 000 10, 000 P 2, 000 -----------

The P/V graph The is profit or loss at any given volume can be shown graphically in a profit-volume (P/V) graph. A P/V graph shows only a single straight line to represent profit. The profit at any volume can thus be determined more readily from a P/V graph than from a break-even chart. The P/V graph for the same examples used in constructing the break-even chart is shown on the following page. The horizontal axis of the graph represents volume, which may be expressed in units, pesos, or percentage of capacity. The vertical axis above the zero point represent profits, while all points below the zero point represent losses.

The profit line can be drawn based on the profits at any two assumed levels. The profits at the zero volume and the maximum volume were used to draw the profit line. The profit and loss at these two volume levels were computed as follows: P(0 units) = P4(0) P2 (0) P10, 000 (P10, 000) P4 (10, 000) P2(10, 000) P10, 000 P10, 000

P(10, 000 units) = =

When the volume is zero, the profit is negative, which is really a loss. The loss is equal to the total fixed costs. This is the point below the zero point where the profit line originates. When the volume is 10, 000 units, the total profit is P10, 000. This is the maximum profit attainable by the business. At the point where the profit line crosses the horizontal axis, the profit is zero. This point is the break-even point. The break-even point in the above graph is 5, 000 units. Any point on the profit line above the break-even point indicates a profit, while any point below the break-even point indicates a loss. The profit or loss at any volume can be readily determined by reading off from the graph. Margin of safety

The margin of safety (M/S) is the difference between actual or budgeted sales at any selected level and the break-even sales. It represents the amount by which sales can be reduced before losses will be incurred. The margin of safety can be expressed in ratio form as follows: M/S ratio = Actual sales break-even sales Actual sales

A glance at the ratio indicates that the greater the difference between the actual sales and the break-even sales, the higher would be the margin of safety ratio. Conversely, the smaller is the difference between the actual sales and the break-even sales, the lower would be the margin of safety ratio. A business with a lower margin of safety is in a more precarious situation than one with a higher ratio. To illustrate the computation of the margin of safety ratio, assume that the actual sales is 6, 000. The margin of safety ratio would be M/S ratio = P24, 000 P2, 000 P24, 000

At a higher level of budgeted or actual sales of 8, 000 units, the margin of safety ratio is M/S ratio = = P32, 000 P20, 000 P32, 000 37.5%

The margin of safety ratio increases as the business moves further away from the break-even point. When the margin of safety ratio and the contribution margin ratio are both known, the profit at any volume above the following equation: P Where P S P/V ratio M/S ratio = = = = = S x P/V ratio x M/S ratio profit actual budgeted sales contribution margin ratio margin of safety ratio

The profit at 6, 000 units using the formula is: P = = P24, 000 x 50% x 1 2/3% P2, 000

Profit planning The break-even formula can be modified to obtain the sales volume required to be attained in order to yield a desired or planned profit. The desired profit, whether before or after taxes, is treated as if it were a fixed cost, and hence is added to the total fixed costs in the numerator of the break-even formula.

The sales volume required to attain a desired profit before tax is calculated from the following equations: Desired sales (in units) = Or Desired sales (in pesos) = TFC ---_Desired profit Unit contribution margin TFC ---_Desired profit Contribution margin ratio

If desired profit is after taxes, the equations are: = Desired sales (in units) Or TFC ---_Desired profit (after tax) 1 - Tax rate Unit contribution margin

= Desired sales (in pesos)

TFC ---_Desired profit (after tax) 1 - Tax rate Contribution margin ratio

Resume, in our example, that the profit planned or desired to be earned is P3, 000 before taxes. The number of units that must be sold to earn this profit is: Desired sales = P10, 000 --- P3, 000 1- .40 P2 7, 500 units

= Sensitivity analysis

Cost-volume-profit relationships can be utilized to determine the effect on profit or the breakeven point of changes in one or more of the factors affecting profit. This type of analysis, which may be referred to as sensitivity analysis, indicates the desirability of a proposed change. It thus enhances the usefulness of cost-volume profit analysis In addition to assisting management in judging the desirability of a proposed change, the analysis can also be used to evaluate several alternatives or proposals to increase profit. The possible changes that could be made are: 1) 2) 3) 4) Changes in the selling price Changes in the variable costs Changes in fixed costs Changes in volume

To illustrate the effect of each of these changes, the following data are assumed:

Selling price are assumed per unit Variable cost per unit Total fixed costs Current sales volume

P10 6 P20, 000 10, 000 units

Changes in selling price Assume that the selling price per unit is to be increased by 20%. The effects of this change on profit and the break-even point are shown below. Increase (Decrease) P120, 000 _______0 P 20, 000 _______0 P 20, 000 --------------

Sales 10, 000 x P10 -10, 000 x P12 Less variable costs Contribution margin Less fixed costs Net income P/V ratio Break-even point

Present P100, 000 60, 000 P 40,000 20, 000 P 20, 000 ------------40% P 50, 000

Proposed P120, 000 60, 000 P 60, 000 20, 000 P 40, 000 ------------50% P 40, 000

An increase in selling price causes an increase in the profit and a decrease in the break-even point due to a higher contribution margin ratio. The changes in the profit and the break-even point are shown in the following P/V graph.

Fig. 5.5 P/V Graph Changes in variable costs Assume that there will be an increase in variable costs of 25%. The effects of this change are shown below. Increase Present Proposed (Decrease) Sales P100, 000 P100, 000 P 0 Less variable costs 10, 000 x p6.00 60, 000 10, 000 x P7.50 ________ _ 75, 000 ___15, 000 Contribution margin P 40, 000 P 25, 000 (15, 000) Less fixed costs ___20, 000 ___20, 000 _________0 Net income P 20, 000 P 5, 000 P (15, 000) ----------------------------------------P/V ratio 40% 25% Break-even point P 50, 000 P 80, 000 An increase in variable costs causes a decrease in the profit and an increase in the break-even point. The increase in the break-even point results from a lower contribution margin ratio. The changes in profit and the break-even point are shown in the P/V graph below.

Fig. 5.6 P/v Graph Changes in fixed costs Assume that the fixed costs are to be increased by 50%. The effects of this change are given in tabular form below. Increase (Decrease) P 0 0 P 0 10, 000 P (10, 000) ----------------

Sales Less variable costs Contribution margin Less fixed costs Net income P/V ratio Break-even point

Present P100, 000 60, 000 P 40, 000 ___20, 000 P 20, 000 ------------40% P 50, 000

Proposed P100, 000 60, 000 P 40, 000 ___30, 000 P 10, 000 -------------40% P 75, 000

An increase in fixed costs causes a decrease in profit. The decrease in profit is equal to the decrease in fixed costs. The increase in fixed costs also increased the break-even point. The increase in break-even point is 50%, the same percentage increase in fixed costs. The increase in the break-even point is attributable to an increase in the fixed costs. The increase is fixed costs has no effect on the contribution margin ratio. A graphical presentation of the changes is shown below.

Units of Product Fig. 5.7 P/V Graph Change in volume Assume that volume will increase by 50%. The increase in volume will have the following effects: Sales 10, 000 x P10 19, 000 x P10 Less variable costs10, 000 x P6 15, 000 x P6 Contribution margin Less fixed costs Net income P/V ratio Break-even point Present P100, 000 Proposed P150, 000 60, 000 ________ P 40, 000 20, 000 P 20, 000 -------------40% P 50, 000 Increase (Decrease) P 50, 000

90, 000 P 60, 000 20, 000 P 40, 000 --------------40% P 50, 000

30, 000 p 20, 000 0 P 20, 000 ---------------

An increase in volume increases the profit by the same amount of increase in the contribution margin. An increase in volume has no effect on the break-down point. While the increase in volume increase both sales and variable costs by the same percentage as the increase in volume, the increase in sales and variable costs had no effect on the contribution margin ratio. An increase in volume has no effect on the profit line in a P/V graph. The profit line remains unchanged but the profit moves to a higher level along the same line. Summary of effects of changes The effects of changes in selling price, variable costs, fixed costs and volume on profit, the contribution margin ratio, and the break-even point are summarized in the following table: Changes 1. Selling price: Increase Decrease Profit Increase Decrease P/V ratio Increase Decrease BEP Decrease Increase

2. Variable costs; Increase Decrease 3. Fixed costs: Increase Decrease 4. Volume: Increase Decrease Multiple changes

Decrease Increase Decrease Increase Increase Decrease

Decrease Increase No effect Increase No effect No effect

Increase Decrease Increase Decrease No effect No effect

When two or more changes, no general rules can be formulated. Each situation must be analyzed according to the circumstances. Resume, for example, that management plans to decrease the selling price by 20%. The decrease in selling price will also lead to an increase in sales volume of 40%. The effects of these combined changes are shown below. Increase Present Proposed (Decrease) Sales 10, 000 x P10 P100, 000 14, 000 x P8 P112, 000 P12, 000 Less variable costs10, 000 x P6 60, 000 14, 000 x P6 ________ 84, 000 24, 000 Contribution margin P 40, 000 P 28, 000 (P 12, 000) Less fixed costs 20, 000 20, 000 0 Net income P 20, 000 P 8, 000 (P 12, 000) -----------------------------------------P/V ratio 40% 25% Break-even point P 50, 000 P 80, 000 The decrease i selling price coupled with an increase in volume caused a decrease in net income, a decrease in the contribution margin ratio, and an increase in the number of units sold, this was not sufficient to effect a decrease in the selling price. Evaluating changes in selling price A decrease in selling price by itself leads to a decrease in profit. A business will decrease its selling price, however, if the decrease in selling price results to an increase in profit due to an increase in volume. In the preceding example, a 20% decrease in selling price caused a 40% increase in volume resulted to a decrease in profit of P12, 000 thus indicating that the increase in volume was not adequate to offset the decrease in selling price.

It is possible to determine the percentage increase in volume that can justify a decrease in selling price. The sales volume that can justify a decrease in price is that sales volume that will yield a profit that is at least equal to the present profit. In a given example, the sales volume required to offset the decrease in price could be computed as follows: Desired sales (in units) = Total fixed cost Present profit Unit contribution margin

P20, 000 P20, 000 P2 = 20, 000 units The increase in the sales volume that is required 10,000 units, which represents a percentage increase of 100%. Thus, it would require a much larger percentage increase in price. If the business could not attain this large increase in volume, then it would be advisable to decrease the current price. The percentage increase in sales units required to offset a decrease in volume can be computed directly by dividing the decrease in the contribution margin by the new contribution margin per unit. Thus, the percentage in sales units required to offset 20% decrease in selling price would be = % increase in sales units = Decrease in contribution margin New contribution margin = P4 P2 P8 P6 = 100% The percentage income in peso sales to offset a decrease in selling price can likewise be computed. The percentage increase in peso sales could be computed as follows: % increase in peso sales = Decrease in contribution margin New contribution margin = 40% 25% 25% = 60% Thus, in order to offset a price decrease of 20%, the total peso sales must be increased by 60% from the present sales of P100,000 to P160,000. To prove that a 20% decrease in selling can be offset by a 100% increase in units sold or 60% increase in peso sales, income statements are prepared below. Present P100,000 60,000 _______ P 40,000 __20,000 P 20,000 Proposed P160,000 120,000 P 40,000 __20,000 P 20,000

Sales 10,000 x P10 20,000 x P8 Less variable costs 10,000 x P6 -20,000 x P6 Contribution margin Less fixed costs Net income

----------Evaluating changes in fixed costs

-----------

Fixed costs may increase because of a increase in capacity. The increase in plant capacity causes fixed costs such as depreciation, property taxes, insurance, heat and light, repairs and maintenance, and other occupancy costs to increase. The fixed costs may also increase because of a decision of management to spend more amounts for much purposes as advertising, sales promotion, charitable contributions, and research and development. If additional fixed costs are incurred, profit will tend to decrease and the break-even point will increase. The increase in fixed costs, however, is expected to increase sales volume. The company must weigh the income in profit resulting from an increase in sales volume against the higher break-even point and the higher sales required to maintain the same present profit. To illustrate, assume that the Omega Co. has a maximum sales capacity of P2,000,000. Fixed costs are P600,000 per year and variable costs are 40% of sales. The company is planning to enlarge present capacity by 50%. This will cause an increase in fixed costs of P150,000. There will be no change in the variable cost ratio. Present operations are at 90% of capacity. At present capacity, the profit is P480,000, as shown in the following income statement: Sales (P2,000,000 x 90%) P 1,800,000 Less variable costs (P1,800,000 x 40%) 720,000 Contribution margin P 1,080,000 Less fixed costs 600,000 Net income P 480,000 -------------The current break-even point is: BEP = P600,000 60% = P1,000,000 If the company will push through with its expansion plan, the profit potential of the company will increase, as shown in the following table: Present Proposed Difference Sales P2,000,000 P3,000,000 P1,000,000 Less variable costs 800,000 1,000,000 400,000 Contribution margin P1,200,000 P1,800,000 P 600,000 Less fixed costs 600,000 750,000 150,000 Net income P 600,000 P1,050,000 P 450,000 ------------------------------------The maximum income attained under the proposed plan is P1,050,000, compared to the present profit potential of P600,000. The disadvantages of increasing plant capacity are the higher break-even point and sales required to attain the present profit. The break-even point under the proposed plan is BEP = P750,000 60% = P1,250,000 The volume of sales that the company must attain in order to maintain the same present profit is

Desired sales = P750,000 / P480,000 60% = P2,050,000 If the company can not reach a sales level of P2,050,000, profit will fall below the present profit being realized. For example, if operations remain at their present level, the company will realize a profit of only P330,000, as shown in the following computation: Profit = P1,800,000 40% x P1,800,000 P750,000 = P330,000 Operating leverage When a company has a high level of fixed costs as well as a high contribution margin ratio (high ratio of sales to variable costs), the company can increase profits by a significantly larger percentage with only a small percentage increase in volume. This phenomenon is referred to as operating leverage. The sensitivity of profits to changes in volume can be measured by the degree of operating leverage or operating leverage factor. The degree of operating leverage at any lvel of operation can be computed by the following formula: Degree of operating leverage = contribution margin Net income The greater the degree of operating leverage, the greater is the percentage increase in profits that would result from a percentage increase in volume. To illustrate, assume that a company produces and sells a product at the following costs and selling price: Variable cost per unit P15 Annual fixed costs P75,000 Selling price per unit P30 Given the above data, the break-even point for the company can be computed, which is BEP = P 75,000 = p15 = 5,000 units If the company is currently selling 6,000 units, the profit of the company is Sales (6,000 x P30) Less variable costs (6,000 x P15) Contribution margin Less fixed costs Net income P 180,000 90,000 P 90,000 75,000 P 15,000 ------------

The degree of operating leverage at the current level of 6,000 units is Degree of operating leverage = P 90,000 P 15,000 =6 If the company were to increase volume by only 10%, or from 6,000 units 6,600 units, the profit of the company would be P24,000, as shown in the following income statement. P 198,000 99,000 P 99,000 75,000 P 24,000 -----------Thus, it is observed that with only 10% increase in volume, profit will increase by 60% (9,000 + P15,000). The percentage increase in profits that will result from a percentage increase in volume can be obtained directly by multiplying the percentage increase in volume by the degree of operating leverage. In the above example, the percentage increase in profit of 60% can be derived as follows: = percentage increase in volume x degree of operating leverage = 10% x 6 = 60% The degree of operating leverage tends to decrease as the output moves further away from the break-even point. For example, at the new level of 6,600 units, the degree of operating leverage is P99,000 P24,000 = 4.125 The degree of operating leverage decreased from 6 to 4.125. The percentage increase in profits would also be lower if volume were to be further increased due to the smaller degree of operating leverage. If, for example, output were further increased by 10% from 6,600 to 7,260 units, the increase in profits would only be = 10% x 4.125 = 41.25% Thus, the profit would increase from P24,000 to P33,900, or by P9,900. This represents an increase of only 41.24%. An income statement prepared for 7,260 shows the new profit level of P33,900: Sales (7,260 units x P30) Less variable costs (7,260 x P15) Contribution margin Less fixed costs Net income P 217,800 180,900 P 108,900 75,000 P 33,900 -----------% increase in profits Degree of operating leverage = % increase in profits Sales (6,600 x P30) Less variable costs (6600 x P15) Contribution margin Less fixed costs Net income

Break-even analysis for multiple products

Break-even analysis can be performed when a company produces several products. To illustrate, assume that a company produces two products. Information related to the two products is given below. Unit Unit Unit Contribution Sales Selling Variable Contribution margin Product mix price Cost margin ratio X 4 P12 P6 P6 50% Y 6 10 6 4 40

Assume that the fixed costs per year are P240,000. To compute the break-even point for the company, it is first necessary to determine the average contribution margin, as indicated below. Unit Contribution margin___ P6 4 Total Contribution margin___ P24 24 P48 = P48 10 = P4.80

Product X Y

Sales mix 4 6 10 Average contribution margin

The break-even point is therefore BEP = P240,000 P4.80 = 50,000 units The break-even point for each product is determined as follows Product X 50,000 units x 4/10 = 20,000 units Product Y 50,000 units x 6/10 = 30,000 units Break-even point in peso sales The break-even point in pesos for multiple products can be directly computed by dividing the total fixed costs by the average contribution margin ratio. To illustrate, consider the following data: Sales Volume (units) 6,000 5,000 Unit selling price P5 4 Unit variable cost P2 2 Unit Contribution margin P3 2 Contribution margin ratio 60% 50

Product A B

Total fixed costs P14,000 To compute the average contribution margin ratio, an income statement for the present sales mix is prepared below. Product A Product B Total

Sales Less variable costs Contribution margin Less fixed costs Net income

P 30,000 12,000 P 18,000

P 20,000 10,000 P 10,000

P50,000 22,000 P28,000 14,000 P14,000 -----------

Average contribution margin ratio

= =

P28,000 P50,000 56%

The break-even point is thus BEP = =

P14,000 56% P25,000

The break-even sales can be broken down per product as follows: Product A P25,000 x 60% Product B P25,000 x 40% = = P15,000 P10,000

The sales mix percentages of 60% for Product A and 40% for Product B are on the total sales for each product. The average contribution margin ratio can also be computed be multiplying the contribution margin ratio for each product by the corresponding sales mix percentage for each product. The computation is as follows: Average Contribution Sales mix contribution Product margin ratio percentage margin ratio A 60% 60% 36% B 50% 40% 20 56% -----Changes in sales mix The product and the break-even point for several products are dependent on a given sales mix. A change in the sales mix alters the profit and the break-even point. To illustrate, consider the following example: Sales Volume (units) 3,000 2,000 Unit Selling price P20 10 Unit Variable cost P12 7 Unit contribution margin P8 3 Contribution margin ratio 40% 30

Product M N

Total fixed costs P12,000 The income of the company at the present sales mix is computed below. Product M P 60,000 36,000 Product N P 20,000 14,000 Total P 8,000 50,000

Sales Less variable costs

Contributed margin

P24,000

P 6,000

P30,000 12,000 P18,000 -----------

The break-even point for the company is: BEP = P12,000 37.5% = P32,000

Assume that the sales of product M and N are 1,000 units and 4,000 units, respectively. The unit selling prices, unit variable costs, and the total fixed costs remain the same. The profit and the break-even point for the company with the change in the sales mix are: Product M P20,000 12,000 P 8,000 Product N P40,000 28,000 P12,000 Total_ P60,000 40,000 P20,000 12,000 P 8,000 ----------

Sales Less variable costs Contributed margin Less fixed costs

Break-even point = P12,000 33 1/3% = P36,000 The change in the sales mix, particularly the shift from the more profitable Product M to the less profitable Product N, has caused the profit to decrease from P18,000 to P8,000 and the break-even point to increase from P32,000 to P36,000. Sales and production not equal When absorption costing is used and sales and production are not equal, the fixed costs charged off as expenses during a given period are not equal to the total fixed costs which are incurred during the same period. When production is greater than sales, some fixed costs of the current period are shifted to future periods as costs of inventory. When sales are greater than production, some fixed costs of prior periods are deducted as expenses of the current period. Consider the following income statement of a company prepared under the absorption costing: Income statement (Absorption Costing) Sales (90,000 units x P15) Less cost of sales: Variable costs (100,000 x P10) Fixed costs (100,000 x P2) Total production cost Less ending inventory (10,000 units x P12) Gross profit on sales Operating expenses: Fixed P 1,350,000 P 1,000,000 200,000 P 1,200,000 120,000 1,080,00 P 270,000

P 50,000

Variable Net income

90,000

140,000 P 130,000 --------------

An income statement prepared under absorption costing generally does not show a fixed and variable cost classification. They are shown in the statement above only to simplify the illustration.

The income statement shows that production ad sales during the period are not equal. The production during the period was 100,000 units while the sales for the same period was 90,000 units. Hence, there was an inventory at the end of the period of 10,000 units. The total fixed costs incurred during the period amounted to P250,000, which consisted of fixed manufacturing costs of P200,000 and fixed operating expenses of P50,000. The total fixed costs expensed during the period, however, was only P230,000, computed as follows: Fixed manufacturing costs Less fixed costs included in ending inventory(10,000 x P2) Fixed manufacturing costs expensed Fixed operating expenses Total fixed costs expensed during period P 200,000 20,000 P 180,000 50,000 P 230,000 -------------

If a cost-volume-profit income statement were to be prepared, the following income would be obtained: Income Statement (Cost-volume-profit analysis) Sales (90,000 units x P15) Less cost of sales: Variable production costs (100,000 x P10) Less ending inventory (10,000 units x P12) Manufacturing margin Less variable operating expenses (90,000 x P1) Contribution margin (90,000 x 4) Les fixed expenses: Fixed manufacturing expenses Fixed operating expenses Net income P 1,350,000

P 1,000,000 100,000 900,000 P 450,000 90,000 P 360,000

250,000 P 110,000 -------------In the cost-volume-profit income statement, fixed manufacturing costs are not included in the cost of inventory. The total fixed manufacturing costs of P120,000 is treated entirely as an expense of the

P 200,000 50,000

period in which it was incurred. Hence, the total fixed costs expressed in the income statement amounts to P250,000. This differs from the P230,000 fixed costs deducted as expenses under absorption costing. This difference in fixed expenses underlies the difference in the income reported under absorption costing and under cost-volume-profit analysis. In computing the break-even point, the fixed expenses under the cost-volume-profit, the fixed expenses under the cost-volume-profit income statement would be used. Hence, the break-even point for the company would be BEP = P 250,000 = P4 = 62,500 units QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. What are the factors that affect the net income of a business? What basic assumptions are made in break-even analysis? State some applications of break-even analysis? What does a break-even graph show? Define the break-even point? What are the different ways in which the break-even point can be expressed? How are income taxes treated in the computation of the break-even point? Define contribution margin. How is the contribution margin ratio computed? What is the relationship of the contribution margin ratio and the variable cost ratio? What is the effect on the contribution margin ratio of a change in (a) volume? (b) fixed costs? What are the limitations of break-even chart? What does a profit-volume graph show? What is its advantage over a break-even point? What is the margin safety ratio? What is its significance? State the effect on the break-even point of each of the following changes: (a) Increase in selling price (b) Increase in unit variable costs (c) Increase in fixed costs (d) Increase in volume 15. What is meant by operating leverage? 16. What conditions must exist for operating leverage to work? 17. How does a shift in sales mix affect (a) the break-even point? (b) the net profit? EXERCISES 1. A company produces and sells a single product. The sales price is P15 per unit. The variable cost to make and sell is P5 per unit. The fixed costs are P30, 000 per year. Required: (1) construct a break-even chart assuming a maximum capacity of 3, 000 units. (2)Construct a profit-volume graph. (3)determine the break-even point (in units).

2. The Bendix Corporation has sales of P8, 000 at full capacity. The variable costs are 60% of sales. The fixed costs of operation are P120, 000 per year. Required: (1)construct a break-even chart. (2)construct a profit-volume graph. (3)determine the break-even sales (in pesos).

3. The Rex Co. sells a product for P50 per unit. The variable cost per unit is P35. Iin year 5, the company sold 6, 000 units and earned a profit of P30, 000. Required: determine the break-even point in units of product for year 5. 4. The LXD Co. sells a product for P25 per unit. The fixed costs are P75, 000 per period. At a sales volume of 6, 000 units, the profit of the company is P15, 000. Required: compute the following: (1) The break-even point in units of product, (2) The profit expected on sales of 8, 000 units.

5. The Zeny Corporation shows the following results of operations for the year ended December 31, 19F: Sales P600, 000 Costs and expenses: Variable P420, 000 Fixed 120, 000 540, 000 Net income before taxes P 60, 000 ------------Required: Determine the following: (a) The break-even point, (b) The profit expected on sale of P750, 000. 6. The records of the Selecta Corporation show the following revenues and costs at two selected levels of operation: A B Unit sold 16, 000 20, 000 Sales P64, 000 P80, 000 Costs and expenses 40, 000 48, 000 Net income P 24, 000 P32, 000 ---------------------Required: Determine the following: (a) Variable cost per unit. (b) Total fixed cost. (c) The break-even point in units.

(d) The break-even point in pesos. 7. A product sells for P45 per unit. The variable cost per unit is P36. The fixed costs for the year amount of P270, 000. Required: (1) the break-even point in units of product. (2)the number of units that must be sold to produce a pretax income of P90, 000. (3)the number of units that must be sold to produce an after-tax income of P54, 000 (assume an income tax rate of 40%). (4)the number of units that must be sold to produce an income before taxes of 5 percent of sales. 8. The budgeted sales of the Alexis Co. for 19B is P600, 000. Variable costs are estimated to average 60% of sales. Fixed costs are budgeted at P100, 000 for the year. (1) the budgeted break-even point. (2)The income expected for 19B. (3)the sales necessary to increase budgeted profit before taxes to P200, 000. (4)the sales necessary to earn a budgeted after-tax income of P120, 000 (assume a tax rate of 40%).

Required:

9. The Gerardo Co. earned an income after tax in 19A of P60, 000. The fixed costs amounted to P200, 000. The contribution margin ratio was 40%. Required: Determine the sales revenue in 19A. 10. A company manufactures a single product which sells at P15 each. The variable cost per unit is P12. The fixed costs are P15, 000. Last year, the company sold 20, 000 units of product. The coming year, the company is contemplating a reduction of 10% of its selling price. Required: How many more units of product must the company sell this year in order to maintain the profit earned last year. 11. The Marjorie Co. has break-even sales of P900, 000, a margin of safety ratio of 40% and a contribution margin ratio of 25%. Required: (a) what is the companys present sales? (b)what is the margin of safety in pesos? (c)what is the income before income taxes? (d)what is the total fixed cost?

12. The Twin Peaks Co. produces a single product which sells for P4 per unit. The variable cost er unit is P2 and the total fixed costs per year are P10, 000. Required: (1) determine the following:

(a) The margin of safety ratio assuming that actual sales is 6, 000 units, (b) The margin of safety ratio assuming actual sales is 8, 000 units. (2)assuming that actual operations resulted in a margin of safety ratio of 25 percent and a contribution margin ratio of 40% , determine the actual income before income taxes if fixed costs are P15, 000 per year. 13. The Perez Co. manufactures and sells a single product. Data related to the product are as follows: Present sales volume Selling price per unit Variable costs per unit Total fixed costs Required: 50, 000 units P3.50 P2.10 P42, 000

(1) Determine the following: (a) The present break-even point in units. (b) The present annual profit. (2)Determine the new break-even point under each of the following assumptions: (a) a 5% increase in fixed costs and a 20% increase in variable costs. (b) a 20% increase in selling price, a 25% increase in variable costs, and a 20% increase in fixed costs. (3) Determine the new profit under each of the following assumptions: (a) a 10% increase in selling price and a 25% increase in fixed costs. (b) a 10% decrease in selling price, a 10% increase in variable costs, and a 20% increase in volume.

14. The Melgar Corporation produces and sells a single product. The budget of operations for a certain period is as follows: Sales Variable costs Contribution margin Fixed costs Net income Required: (a) (b) (c) (d) (e) (f) Determine the expected profit under each of the following assumptions: Selling price is increased by 10%. Variable costs are decreased by 15%. Fixed costs are decreased by 25%. Sales volume is increased by 20%. Fixed costs are increased by 10% and selling price is increased by 5%. Variable costs are increased by 10% and sales volume is increased by 20%. P600,000 450,000 P150,000 90,000 P 60,000 ------------

15. A company sells a product for P8 per unit. The costs to make and sell the product are as follows:

Variable costs Fixed costs

P4 per unit P250,000 per year

The company presently sells 150,000 units of the product. The sales manager believes that a reduction of the selling price by 20% will increase the present sales volume by 50% and thereby increase the present profit. Required: managers (1) Would it be advisable to decrease the selling price in accordance with the sales

suggestions? Show computation. (2) What percentage increase in unit sales volume is required to offset a 20% decrease in selling price? 16. A company is presently selling a product for P100 per unit. The variable cost per unit is P60, and the total fixed costs are P600,000. The present volume of sales is 10,000 units. Required: (1) What percentage increase in sales units will offset a decrease in selling price of (a) 10% (b) 20% (2) What percentage increase in peso sales volume will offset a decrease in selling price of (a) 15% (b) 25% 17. The data for two companies selling the same type of product given below. Company X P15 P 9 P60,000 Company Y P12 P 8 P48,000

Selling price per unit Variable costs per unit Fixed costs Required:

Compute the following: (1) The break-even point for the two companies. (2) The sales volume where the two companies have the same profit. (3) The range of sales where one company is more profitable than the other.

18. The Tidewater company produces and sells a product at the following selling price ad costs: Selling price per unit Variable cost per unit Annual fixed costs Required: P30.00 P15.00 P75,000.00

(a) Compute the degree of operating leverage at 6,000 units. (b) What percentage increase in profits would result if the number of units sold were to

be increased by 10%. 19. The Garcia Company produces and sells two products: X and Y. The selling prices and variable costs associated with each of these two product are as follows: Product X P7 3 Product Y P6 4

Selling price per unit Variable cost per unit

The company plans to sell 5,000 units of Product X and 15,000 units of Product Y during the forthcoming period. The fixed costs of the company per period are P30,000. Required: (1) Determine the total number of units of each product that must be sold for the company to break even. (2) Determine the net income budgeted for the coming period. 20. A company produces and sells two products with the following unit selling prices and unit variable costs: A P5.40 3.24 B P4.80 3.36

Selling price per unit Variable cost per unit

The total fixed cost per year is P76,000. The standard mix, measured in sales revenue, is 80 percent of A and 20 percent of B. Required: (1) Compute the total sales revenue at the break-even point. (2) Compute the sales revenue for each product at the break-even point. 21. The Alexander Co. produces a single product which it sells for P10 per unit. The standard capacity of the company is 100,000 units per year. The standard costs to produce a unit of product are as follows: Variable costs Fixed costs P3.00 1.50

Variable selling and administrative expenses are P2.00 per unit. Fixed selling and administrative expense amount to P75,000 per year. In 19A, the company produced 80,000 units and sold 60,000 units. Required: (1) What was the net income earned by the company in 19A according to cost-volumeprofit analysis? (2) What was the break-even point in 19A?

22. Calica Co. sells radios for P60 each. Variable expenses are P40 per unit, while fixed expenses total P30,000. 1. How many radios must Calica sell to earn an operating income of P70,000? a. 5,000 b. 3,500 c. 2,500 d. 1,500

2. What total peso amount must Calica sell to break even? a. P 40,000 b. P 75,000 c. P 90,000 d. P120,000 AICPA 23. In planning its operations for 19A based on a sales forecast of P6,000,000, Wilfredo, Inc, prepared the following estimated data: Cost and expanses Variable__ Fixed__ P1,600,000 1,400,000 600,000 P 900,000 240,000 360,000 60,000 140,000 P3,900,000 P1,400,000 ---------------------------

Direct materials Direct labor Factory overhead Selling expenses Administrative expenses

What would be the amount of sales pesos at the break-even point? a. P2,250,000 b. P3,500,000 c. P4,000,000 d. P5,300,000 AICPA 24. Carreon Co.s 19C operating percentages were as follows: Sales Cost of sales Variable Fixed Gross profit Other operating expenses Variable Fixed Operating income 100% 50% 10

60 40

20 15

35 5%

----Carreons 19C sales totalled P2,000,000. At what 19C sales level would Carreon break even? a. P1,900,000 b. P1,666,667 c. P1,250,000 d. P 833,333 AICPA 25. Tommy Co. has sales of P200,000 with variable expenses of P150,000, fixed expenses of P60,000, and an operating loss of P10,000. By how much would Tommy have to increase its sales in order to achieve an operating income of 19% of sales? a. b. c. d. P400,000 P251,000 P231,000 P200,000

AICPA 26. Linda company reported the following results from sales of 5,000 units of Product A for the month of June, 19A: Sales Variable costs Fixed costs Operating income P200,000 120,000 60,000 20,000

Assume that Linda increases the selling price of Product A by 10% on July 1, 19A. How many units of product A would have to be sold in July, 19A in order to generate an operating income of P20,000? a. 4,000 b. 4,300 c. 4,500 d. 5,000 AICPA 27. Vinoya Company is planning its advertising campaign for 19A and has prepared the following budget data based on a zero advertising expenditure: Normal plant capacity Sales Selling price Variable manufacturing costs Fixed costs: Manufacturing Selling and administrative 200,000 units 150,000 units P25.00 per unit P15.00 per unit P800,000 P700,000

An advertising agency claims that an aggressive advertising campaign would enable Vinoya to increase its unit sales by 20%. What is the maximum amount that Vinoya can pay for the advertising and obtain an operating profit of P200,000? a. P100,000

b. P200,000 c. P300,000 d. P550,000 AICPA 28. The following data pertain to two types of products manufactured by Corina Corp.: Sales price per unit P120 500 Variable costs per unit P 70 200

Product Y Product Z

Fixed costs total P300,000 annually. The expected mix in units is 60% for Product Y and 40% for Product Z. 1. How much is Corinas break-even sales in units? a. 857 b. 1,111 c. 2,000 d. 2,459 2. How much is Corinas break-even sales in pesos? a. P300,00 b. P420,000 c. P475,000 d. P544,000 AICPA PROBLEMS 5.1 The Fajardo Co. sells its product at P24 per unit. The costs of making and selling 9,000 units of this product are estimated as follows: Direct materials Direct labor Factory overhead: Variable Fixed Selling and administrative (70% fixed) Required: 5.2 Determine the break-even point in (a) units of product, (b) peso sales. P45,000 36,000 18,000 27,000 30,000

A local hotel has a capacity of 100 rooms. The fixed costs of operation amount to P108,000 per month, and the average daily variable cost per room rented is P120. The average daily room rate is P300. The hotel operates 30 days per month.

Required: occupancy.

(1) Compute the break-even point in (a) number of rooms rented, (b) percentage of (2) Compute the income at a percentage occupancy of 80 percent.

5.3 A company produces a product which is sold at P30 per unit. The variable costs to make and sell a unit of product are 40% of sales price. The total fixed costs are P72,000 per month. Required: (1) Construct a break-even chart assuming a maximum capacity of 9,000 units. (2) Determine the break-even point in units of product. (3) Determine the profit expected on sales of 8,000 units. (4) Determine the sales revenue required to yield a pretax income of P36,000. (5) Determine the sales revenue required to yield annual income of 10% of sales before taxes. (6) Determine the sales revenue required to yield an after-tax income of P27,000 assuming the tax rate is 25% 5.4 Budgeted data of the Galera Manufacturing co. for 19C appears as follows: Budgeted sales Budgeted selling price 30,000 units P100.00 Variable costs Fixed costs

Costs and expenses: Direct materials P20 Direct labor 18 Factory overhead 15 Selling expenses 5 General and administrative 2 Required:

60,000 120,000 80,000

Determine the following: (1) The break-even point in units of product. (2) The budgeted net income. (3) Te break-even point if direct materials cost increases by P5.00 per unit. (4) The break-even point if direct labor cost increases by P2 per unit and fixed factory overhead increases by P10,000. (5) The break-even point if the selling price increases by P5 per unit, variable selling expenses increase by P3 per unit, and fixed administrative expenses decrease by P14,000.

5.5 The monthly income statement of the Angelita Company is as follows: Sales Costs and expenses: Variable Fixed Net income P5,000,000 P3,000,000 1,000,000

4,000,000 P1,000,000 --------------

Required: (1) What is the break-even point of the company.

(2) What will be the effect on the break-even point and the net income of each of the following changes: a. An increase in selling price of 20% b. An increase in variable costs of 25% c. An increase in fixed costs of 50% d. An increase in volume of 10% (3) What is the effect on the break-even point and the net income of the following changes taken together: a. Decrease in selling price by 10% b. In volume by 20% and c. Increase in fixed costs by 25%.

5.6 The following statement has been prepared from the records of the Benjamin Co.: Sales Costs and expenses: Variable (40% of sales) Fixed Net income P900,000 P360,000 412,500

722,500 P127,500 -----------The Benjamin Co. is presently operating at 80 percent of its maximum capacity.

Required: (1) Calculate the break-even point. (2) Calculate the income at maximum capacity. (3) Calculate the break-even point if direct materials increase by 20% and direct labor costs increase by 15%, and direct materials and direct labor costs are 40% and 30% of total variable costs, respectively. 5.7 An analysis of the costs of the Toledo Company disclosed the following information: Variable costs (percentage of sales) 30% 20 8 7 5

Cost elements Direct materials Direct labor Factory overhead Selling expenses Administrative expenses

Fixed costs

P96,000 44,000 40,000

Required: Determine the following: (1) Break-even point. (2) Assuming that materials cause increase by 20%, what would be a. The new variable cost ratio? b. The new marginal contribution ratio?

c. The new break-even point? (3) Assume that selling prices are to be reduce by 20% and that advertising expenses increase by P16,000, what would be a. The new variable cost ratio? b. The new contribution margin ratio? c. The new break-even point? (4) What amount of sales is necessary to earn a profit of 10% of sales under existing conditions? 5.8 The present sales of the Celino Company are 100,000 units per year. The sales price per unit is P5 and the contribution margin ratio is 40%. Total fixed cost are P12,000 per year. The company is planning to reduce its selling price by 20%. Required: (1) The present break-even point. (2) The profit at the current sales level. (3) The percentage increase in sales pesos required to offset a 20% decrease in selling price. (4) The new peso volume of sales to earn the same current net income. (5) The new break-even point in units of product. 5.9 The Lawrence Corporation has a net income of P80,000 at a sales volume of 10,000 units. The selling price of each units of product is P40. The fixed costs amount to P120,000 per period. Required: (1) What is the break-even point in units and in pesos? (2) What increase in the number of units sold is required to offset each of the following changes: a. Decrease in selling price of 10%? b. Increase in variable cost price of 20%? c. Increase in fixed costs of 15%? (3) What percentage increase in selling price is required to offset a 20% increase in variable cost? (4) What decrease in variable cause per unit is required to offset a 20% increase in fixed costs in order to maintain the same income? (5) What decrease in variable cost per unit is required to offset a 20% increase in fixed cost in order to maintain the same break-even point? 5.10 The Madeline Co. earns a profit after tax of P24,000 on sales of P280,000. The tax rate of the company is 40%. Each unit of product sells for P40, and the variable cost is P30 per unit. Required: (a) What is the companys break-even point in units? (b) What number of units must be sold in order to maintain the present after-tax net income of selling price is to be reduced by P5 per unit? (c) What increase in the selling price is required in order to maintain the same break-even point if advertising expenses will increase fixed costs by P6,000?

5.11 The Benito Co. sold 200,000 units of its only product last year at a price per unit of P20. The variable cost per unit was P12. The fixed costs for the year amounted to P640,000. Next year, the company plans to sell the same number of units at P24 per unit. The total fixed costs and the unit variable costs are expected to remain the same. Required: (1) What was the break-even sales last year? (2) What was the margin of safety ratio last year? (3) What is the estimated break-even sales next year? (4) What is the estimated margin of safety ratio next year? (5) By how much is the profit expected to change? 5.12 The operations of the Hulog Co. for 19C showed the following results: Sales Variable costs Contribution margin Fixed expenses Net income P800,000 540,000 P260,000 227,500 P 32,500 ----------

Required: (1) What was the break-even point in 19C? (2) What was the margin of safety ratio in 19C? (3) What was the degree of operating leverage in 19C? (4) If sales volume were to be increased by 20% during the following year with no increase in sales prices and costs, by what percentage will the net income increase? Prepare an income statement to support your answer. 5.13 The Quality Products Co. produces three products: A, B and C. Data related to the three products are given below. Product B C P12 P10 9 8 P184,000

Selling price per unit Variable costs Total fixed cost

A P6 5

The company plans to sell 20,000 units, 50,000 units, and 30,000 units of A, B and C, respectively, during the forthcoming year. Required: (a) Determine the number of units of each product that must be sold in order to break even? (b) Determine (a) the total contribution margin, and (b) the total net income planned for rhe coming year.

(c) Determine the break-even point per product assuming that 50,000 units of A, 10,000 units of B, and 40,000 units of C were actually sold. 5.14 a company produces two products, A and B, using joint facilities. The operations of the company for the coming year have been budgeted as follows: Product A P120,000 90,000 P30,000 Product B P80,000 52,000 P28,000 Product C P200,000 142,000 P 58,000

Sales Variable costs Contribution margin (carried forward) Contribution margin (brought forward) Fixed costs Net income

P30,000

P28,000

P58,000 43,500 P14, 500 ----------

The actual sales for the budgeted year were as follows: Product A P150, 000 Product B - 50,000 P200, 000 -----------There were no difference between the actual and budgeted sales prices and costs. Required: (1) determine the break-even point per product based on the budgeted data. (2) Determine the actual net income for the year. (3) Account for the difference between the actual income and budgeted income in terms of the change in the average contribution margin ratio. 5.15 The income statement of the Oliver Company prepared under absorption costing is given below. Sales Cost of goods sold: Beginning inventory Manufacturing costs: Variable Fixed Ending inventory Gross profit Operating expenses: Selling Administrative P96, 000 P4, 000 P27, 000 9, 000

36, 000 P40, 000 8, 000

32, 000 P64, 000

P28, 000 10, 000

38, 000

Net income Data on physical quantities are as follows: Beginning inventory Production Total available Ending inventory Sales

P26, 000 -----------

1, 000 9, 000 10, 000 2, 000 8, 000 --------The selling expenses consist of fixed expenses of P20, 000 and variable expenses of P1.00 peer unit. The administrative expenses are all fixed. Required: (1) Determine the break-even point in units. (2) Determine the net income according to cost-volume profit analysis. 5.16 Seco Corp. A wholesale supply company engages independent sales agent to market the company lines. These agents currently receive a commission of 20% of sales, but they are demanding an increase to 25% of sales made during the year ending December 31, 19B. Seco had already prepared its 19B budget before learning of the agents demand for an increase in commissions. The following pro forma income statement is based on this budget: Seco Corp. PRO FORMA INCOME STATEMENT For the Year Ending December 31, 19B Sales Cost of sales Gross margin Selling and administrative costs Commissions All other costs (fixed) Income before income tax Income tax Net income P10, 000, 000 6, 000, 000 4, 000, 000 P2, 000, 000 100, 000

2, 100, 000 P 1, 900, 000 570, 000 P1, 330, 000 ---------------Seco is considering the possibility of employing its own salespersons. Three individuals would be required, at an estimated annual salary of P30, 000 each, plus commissions of 5% of sales. In addition, a sales manager would be employed at a fixed annual salary of P160, 000. All other fixed costs, as well as the variable cost percentages, would remain the same as the estimates in the 19B pro forma income statement. Required: (a) Compute Secos estimated break-even point in sales pesos for the year ending December 31 19B based on the pro form income statement prepared by the company.

(b) Compute Secos estimated break-even point in sales pesos for the year ending December 31, 19B if the company employs its own salespersons. (c) Compute the estimated volume in sales pesos that would be required for the year ending December 31, 19B to yield the same net income as projected in the pro forma income statement, if Seco continues to use the independent sales agents and agrees to their demand for a 25% sales commission. (d) Compute the estimated volume in sales pesos that would generate an identical net income for the year ending December 31, 19B, regardless of whether Seco employs its salespersons or continues to use the independent sales agents and pays them a 25% commission. AICPA Chapter 6 Gross Profit Analysis Gross Profit Analysis The gross profit, or gross margin, is simply the difference between net sales and the cost of goods sold. In merchandising as well as manufacturing firms, sales constitute the main source of income while cost of goods sold represents the single largest expense item. In manufacturing firm, the cost of goods sold consists of three cost elements - direct materials, direct labor, and factory overhead. An analysis of the changes in sales and cost of goods sold and how they affect gross profit is therefore significant. Gross profit analysis is concerned with the changes in the gross profit and the causes of such changes. The analysis of gross profit may be based on the actual figures of the previous year or on the budgeted or on standard figures for sales and cost of sales. Factors affecting gross profit The amount of gross profit is dependent on four factors, namely: 1.) Selling Prices 2.) Cost prices 3.) Sales volume 4.) Sales Mix Sales mix, however, is a type of volume change. Thus, there are three main factors affecting gross profit: sales prices, cost prices, and volume. Net sales are affected by changes in selling prices and sales volume. On the other hand cost of goods sold is affected by changes in cost prices and volume. Volume, therefore, is a factor common to sales and cost of goods sold. The following assumptions are made in relation to the factors affecting gross profit: 1.) The selling price is assumed to be uniform for all units sold during a period. 2.) The unit cost of goods sold is likewise assumed to be uniform for all units sold during a given period. Procedures using quantities: Two-way analysis thru factor

When sales prices, unit costs, and sales volume are available, gross profit analysis can be performed utilizing quantity figures. To illustrate, assume the following data for the Sunrise Co.: December 31 19A 19B Increase Net Sales P200, 000 P242, 000 P42, 000 Cost of Sales 150, 000 P173, 250 23, 250 Gross Profit P 50, 000 P 68, 750 P18, 750

Units sold Selling price Unit cost

2,000 P100 P75

2,200 P110 P78.75

200 P10 P 3.75

The gross profit of the company increased by P18,750 in 19B. This increase was caused by an increase in net sales of P42,000 and an increase in cost of sales of P23,250. The increase in net sales of P42, 500 can be analyzed in terms of sales and volume changes, as follows: Increase in net sales due to increase in sales price: 19B Actual Sales (2,200 units x P110) 19B sales at 19A prices (2,200 units x P100)

P242,000 P220,000 P 22,000

Increase in net sales due to increase in sales volume: 19B sales at 19A prices (2,200 units x P100) 19A actual sales (2,000 units x P100)

P220,000 P200,000 P 20,000

To determine the effect of a change in selling price on net sales, the sales volume is held constant. Similarly, to determine the effect of a change in sales volume on net sales, the other factor, which is the selling price, is held constant. The increase in net sales caused by changes in selling price and sales volume are shown in the following diagram: Selling Price P110

Price Factor- P22,000 P100 ----------

19A Sales P200,000

Volume Factor P 20,000

Sales Volume Fig. 6.1 (units) The increase in cost of sales of P23,250 can be similarly analyzed in terms of cost price and volume changes, as shown below. 0 2 ,000 2,200 Increase in cost of goods sold due to increase in cost price: 19B actual cost of sales (2, 200 units x P78.75) 19A cost of sales as 19A costs (2, 200 units x P75)

P173,250 165,000 P 8,250

Increase in cost of goods sold due to increase in sales volume: 19A cost of sales as 19A costs (2, 200 units x P75) 19A actual cost of sales (2,000 units x P75)

P165,000 150,000 P 15,000

A formal statement summarizing the changes in net sales, cost of sales, and gross profit is presented below. Sunrise Co. Statement of Accounting for Variation in Gross Profit For the Years Ended December 31, 19A and 19B \ The gross profit increased due to: Increase in net sales due to increase in sales price: 19B Actual Sales P242,000 19B sales at 19A prices 220,000 P 22,000 Increase in net sales due to increase in sales volume: 19B sales at 19A prices P220,000 19A actual sales 200,000 20,000 Increase in net sales P42,000

Increase in cost of sales due to increase in cost price: 19B actual cost of sales 19B cost of sales at 19A costs Increase in cost of sales due to increase in sales volume: 19B cost of sales at 19A costs 19A actual cost of sales Increase of cost of sales Increase in gross profit

P173,250 165,000 P165,000 150,000

P8,250

15,000 23,250 P18,750

Procedures using quantities: Three-way analysis The change in the gross profit may be analyzed in terms of the effects of price, volume, and volume-price factors on net sales and cost of sales. The increase in net sales of P42,000 would be analyzed as follows: Increase in net sales due to increase in sales price (2,000 units x P10) P20,000 Increase in net sales due to increase in volume (200 units x P100) 20,000 Increase in net sales due to joint increase in price and increase in volume (200 units x P10 ) 2,000 Increase in net sales P42,000 The increase in net sales due to the increase in sales price is obtained by multiplying the units sold in 19A by the increase in selling price. The increase in sales due to the increase in sales volume is derived by multiplying the selling price in 19A by the increase in units sold. The increase in net sales due to the combined effect of the increase in selling price and increase in volume is simply the increase in units sold multiplied by the increase in selling price. A graphical illustration of the increases in net sales caused by the sales price , sales volume, and volume-price factors is shown below. Selling Price P110 Price Factor- P20,000 P100 Volume price P2,000 factor ----------

19A Sales P200,000

Volume Factor P 20,000 Sales Volume (units)

0 Fig. 6.2

2 ,000

2,200

The increase in cost of sales may likewise be analyzed in the same manner, as follows: Increase in cost of sales due to increase in cost price (2,000 units x P3.75) Increase in cost of sales due to increase in volume ( 200 units x P P75 ) Increase in cost of sales due to joint increase in cost price and increase in sales volume (200 units x P3.75) Increase in cost of sales

P7,500 15,000 750 P23,250

A summary of the changes in net sales and cost of sales caused by price, volume, and volumeprice factors is presented below. Gross profit increased due to: Increase in net sales: Price factor Volume factor Volume-price factor Less increase in cost of sales: Price factor Volume factor Volume-price factor Increase in gross profit

P20,000 20,000 2,000 P 7,500 15,000 750

P42,000

23,250 P18,750

Chapter 7 Standard cost I Standard cost, defined Standard costs are carefully predetermined costs of producing a unit product. They are costs which should be incurred in a future period, in contrast to actual or historical costs which have been incurred in the past. A standard cost is composed of two standards: a quantity or physical standard and a price (or rate) standard. The standard cost is obtained by multiplying the standard quantity by the standard price (or rate). The standard cost of a unit of product is the sum of the standard costs for materials, direct labor, and factory overhead. Uses of standard costs Standard costs are used for the following purposes: 1) To determine the cost of a product. Standard costs may be used in lieu of actual or historical cost. 2) To obtain estimates or budget of costs. A budgeted cost is obtained by multiplying the total number units produced or sold by the standard cost. 3) To serve as bases for comparing and evaluating actual costs. In other words, standard costs standard costs are used for controlling costs. 4) To aid in establishing sales or bid prices and in making other decisions. 5) To save bookkeeping and clerical costs by simplifying record keeping procedures. Types of standards Standards may be classified according to varying degrees of attainability. According to varying degrees of attainability, standards may be classified as follows: 1) Perfection or ideal standards 2) Current attainable standards 3) Loose standards A perfection or ideal standard is a tight standard. It provides no allowances for spoilage, waste of materials, inefficiency, idle time, unavoidable delays, and machine breakdowns. It assumes that the plant will be operating at full capacity without interruptions or stoppages. When a perfection standard is used, costs are expected to be at a minimum. The concept, however, is unrealistic. It is incapable of attainment and only leads to discouragement and frustration on part of the workers. A current attainable standard is one which can be achieved under efficient operating conditions. It makes allowances for spoilage, machine breakdowns and idle time.

While a current attainable standard is difficult to attain, it is capable of being reached under efficient operating conditions. Hence, it is widely used to motivate and provide incentives to workers. A loosed standard is one which is easily achieved by workers. It is not conducive to the efficient use of materials, labor, and machines. As a result, costs tend to be high when loose standard is adopted. A loose standard is little practical value since it does not motivate workers to achieve their best performance. Setting materials standard There are two standards to be established for direct materials. 1. A standard quantity, and 2. Standard price A materials quantity standard is based on input-output relationships or product specifications which indicate the type of quantity of materials required to produce a unit of product. Product specifications are established through the use of engineering estimates or observation of past experience in setting materials quantity standards, spoilage, and wastage but not for such factors as careless materials handling or processing and abnormal losses. The materials price standard is the most favorable price that could be paid for the type of material to be used in producing the product. Standard is determined after a consideration of such factors as economical order quantities, prevailing prices of materials, quality of material, and sources of supply. The materials price standard should include freight and other incidental costs but exclude cash or quantity discounts. The standard materials cost of a unit of product is computed by multiplying the standard quantity by the standard price. To illustrate, assume that the Aurora Corporation, which uses standard cost system, requires 10 units of material in producing a unit of product. The best price for the material has been determined to be P.90 per unit. The standard materials cost is P9.00 (10 units x P.90). Setting labor standards The two standards to be established for direct labor are 1) A time standard, and 2) A rate standard The labor time standard is the amount of time required to manufacture a unit of product in an efficient manner. It consists of the time standards for all the operations involved in manufacturing a unit of output. The time required to perform all the operations needed to produce the product may be determined through observation of actual experience or by time and motion studies. Allowances are made for unavoidable delays, fatigue, and idle time.

The standard rate to be paid for labor may be established by company policies or wage agreements. The wage rate may be a rate per hour, a piece rate, or a daily, weekly, or semimonthly rate. Standard labor rate, however, should be expressed as a rate per hour or a piece rate. Standard labor cost is obtained by multiplying the standard time by the standard rate. Where the wage rate is a piece rate, becomes the standard labor cost. The Aurora Corporation requires 2 hours to produce a unit of product. The rate per hour is P7.50. Standard labor cost of the company is therefore P15.00 (2 hours x P7.50). Setting standard overhead costs There are also two standards to be set up for overhead costs: 1) A standard quantity, and 2) A standard rate The standard quantity for overhead refers to the basis which is used in applying overhead to products. Factory overhead can be applied on the basis of output, which is measured in units of product, or on the basis of input, such as labor hours, machine hours, direct materials, or direct labor. The standard overhead is based on a standard capacity and a budget of overhead costs. To determine a standard overhead rate, the standard capacity must be selected and the overhead costs at standard capacity must be estimated or budgeted. The overhead rate is computed by dividing the budgeted overhead by the standard volume of production. Two overhead rates can be computed: a standard variable overhead rate and a standard fixed overhead rate. The sum of the variable and the fixed overhead rates is equal to the total overhead rate. The standard overhead cost is derived by multiplying the standard quantity by the total overhead rate. Selecting a standard capacity There are four concepts of capacity which can be chosen in computing overhead rates. These are: 1) Theoretical, maximum, or ideal capacity 2) Practical capacity 3) Normal capacity 4) Expected actual capacity Theoretical capacity is the volume of production which the business would attain if it operates continuously at a peak capacity. It is equal to 100% of the plant capacity. No allowances are provided for unavoidable interruptions such as breakdowns, repairs and maintenance, machine set-up, Sundays, vacations, and holidays. Hence, it is an unrealistic concept. Practical capacity is the volume of production at which the plant can operate efficiently. It makes allowances for unavoidable interruptions, repairs, breakdowns, set-up, Sundays, vacations, and holidays. Allowances are not made, however, for inadequate sales demand.

Normal capacity is a long-range concept of capacity. It is the average volume of production over a number of years long enough to level out cyclical or seasonal fluctuations. It considers lack of sales orders and is thus usually below practical capacity. Expected actual capacity is a short range concept of capacity. It is the volume of production required to meet sales demand for the following year. Cyclical fluctuations in sales demand are not eliminated when expected actual capacity is used. Measures capacity Capacity may be measured in terms of output or input volume. Output volume is expressed in units of product. Input volume may be expressed in labor hours, machine hours, labor cost, material cost, or some other measure. The volume selected to measure capacity should be closely related to the overhead costs. For example, if overhead costs are primarily labor related, labor hours or labor costs should be used as the base for calculating a standard application rate. Budgeting overhead cost Overhead costs can be budgeted using either a fixed or flexible budget. A fixed budget, also called a static budget, is prepared for only one level of activity. It does not provide budget allowances at other volumes. It is therefore limited utility. A flexible budget is prepared for various levels of activity. It can be adjusted to the actual volume or capacity attained.A flexible budget of overhead costs for the Aurora Corp. is presented below. Aurora Corp. Monthly Flexible budget Factory Overhead Percentage of standard capacity Units of production Labor hours Variable Costs: Indirect Materials Supplies Power Repairs and Maintenance Total Variable Overhead Fixed Costs: Supervision Depreciation Insurance Repairs and Maintenance Total Fixed Overhead Total Factory Overhead 80% 2,000 4,000 100% 2,500 5,000 120% 3,000 6,000

P2,800 1,200 2,400 1,600 P8,000 P8,000 4,000 2,000 1,000 P15,000 P23,000

P3,500 1,500 3,000 2,000 P10,000 P8,000 4,000 2,000 1,000 P15,000 P25,000

P4,200 1,800 3,600 2,400 P12,000 P8,000 4,000 2,000 1,000 P15,000 P27,000

The standard capacity of the Aurora Corporation, is 5,000 hours per month. In terms of units of production the standard capacity is 2,500 units of product. The factory overhead rates for the Aurora Corporation are: Variable Overhead rate (P10,000 / 5,000 hours) P2.00 per hour Fixed Overhead rate (P15,000 / 5,000 hours) 3.00 Total Overhead rate (P25,000 / 5,000 hours) P5.00 per hour The variable overhead rate per hour is constant at all volume levels. Hence, it can be obtained at any volume of production. The fixed overhead rate, however, can be computed only at the standard capacity of 5,000 hours. At any other production volume, the fixed overhead rate would be different. Standard Cost Card A standard cost sheet or card provides a summary of the standard cost of producing a unit of product. The standard cost of a unit of product for the Aurora Corporation is summarized below. Standard Cost Sheet Direct Materials(10 units @ P.90) Direct Labor (2 hours @ P7.70) Factory Overhead: Variable (2 hours @ P2.00) Fixed (2 hours @ P3.00) Total standard cost P9.00 15.00 P4.00 6.00

10.00 P34.00

Variance Computation A variance is the difference between actual costs and standard costs. It is obtained by subtracting the standard cost from all the actual costs. If the actual cost is larger than the standard cost, the difference would be positive and the variance is unfavorable. If the actual cost is lesser than the variance cost, the difference would be negative, and the variance is favorable. An unfavorable variance does not necessarily indicate that the variance does not necessarily indicate that the variance is bad. Likewise, a favorable variance does not necessarily suggest that performance is good. The terms favorable or unfavorable merely indicate the direction of the variance from the standard cost. Whether the variance is good or bad depends upon an analysis of the causes of the variance. Material variances Two variances can be computed for direct materials: 1) Materials price variance 2) Materials quantity variance

A material price variance is due to a difference between the actual price paid for direct materials and the standard price that should have been paid for the same materials. A materials quantity variance arises when there is a difference between the actual quantity of materials used and the standard quantity allowed for the production of a unit or units of product. To illustrate the computation of direct materials variances, the following actual data for the Aurora Corp. are assumed: Materials purchased 30,000 units @ P1.00 Materials used Units produced P30,000 22,000 units 2,400 units

Materials price variance The materials price variance can be computed either at the time of purchase or at the time of usage. The materials price variance is computed at the time of purchase if the materials are recorded at standard costs. The materials price variance is computed at the time of usage if the materials are recorded at actual costs. When the price variance is computed at the time of purchase, the computation is based on the actual quantity of materials purchased. When the variance is computed at the time of usage, the computation is based on the actual quantity of materials used. The two methods are illustrated below: Materials price variance computed at time of purchase: (Materials recorded at actual costs) Actual quantity purchased x actual unit price (30,000 units x P1.00) Actual quantity purchased x standard unit price (30,000 units x P0.90) Materials price variance-unfavorable (30,000 units x P0.10)

P30,000 27,000 P3,000

When the price variance is being computed, the quantities purchased are held constant. Hence, the materials price variance can be obtained by simply multiplying the actual quantity purchased by the difference between the actual unit price and the standard unit price. Materials price variance computed at the time of usage: (Materials recorded at actual costs) Actual quantity used x actual unit price (22,000 units x P1.00) Actual quantity used x standard unit price (22,000 units x P0.90) Materials price variance-unfavorable (22,000 units x P0.10)

P22,000 19,800 P 2,200

Materials quantity variance The materials quantity variance, also called the materials efficiency or materials usage variance is computed at the time materials are used. The materials price variance is computed as follows: Actual quantity used x standard unit price (22,000 units x P0.90) P19,800 Standard quantity allowed x standard unit price (24,000 units x P0.90) 21,600 Materials quantity variance-favorable ( 2,000 units x P0.90) (P1,800)

The standard quantity allowed for the production of the completed units is computed by multiplying the units completed or finished by the standard materials quantity per unit of finished product, or 2,400 finished units x 10 units of material per unit of output. The materials quantity variance is simply the difference in quantities multiplied by the standard unit price. The standard unit price is held constant. Labor variance For direct labor, the two variances are: 1) Labor rate variance 2) Labor efficiency variance To illustrate, assume the following data on actual labor costs for the Aurora Corp. Actual hours worked 4,600 hours Actual labor rate paid P7.75 per hour Labor rate variance The labor rate variance is computed as follows: Actual hours worked x actual rate (4,600 hours x P7.75) Actual hours worked x standard rate (4,600 hours x P7.50) Labor rate variance- unfavorable (4,600 hours x P0.25)

P35,650 34,500 P 1,150

The labor rate variance is caused by a difference between the actual rate and the standard rate. The variance can be derived directly by multiplying the difference in the rates by the actual hours worked. Labor efficiency variance The labor efficiency variance, also called the labor quantity variance, is computed on the following page.

Actual hours worked x standard rate (4,600 hours x P7.50) Standard hours allowed x standard rate (4,800 hours x P7.50) Labor efficiency variance- favorable (200 hours x P0.25)

P34,500 36,000 (P 1,500)

The standard hours allowed for producing the completed units is derived by multiplying the actual output of 2,400 units by the standard hours per unit of product of 2 hours. The labor efficiency variance is caused by a difference between the actual hours worked and the standard hours allowed. The variance can be computed directly by multiplying the difference in hours by the standard rate per hour, which is the constant factor. Factory overhead variance The factory overhead variance is the difference between the actual factory overhead incurred and the factory overhead supplied to the products. The factory overhead variance can be analyzed using any of the following methods: 1) Two-variance method 2) Three-variance method 3) Four-variance method To illustrate, assume the following data for the Aurora Corporation. Actual factory overhead: Variable Fixed All other facts assumed in the preceding examples remain unchanged.

P10,000 15,000

Two-variance method The two variances under this method are: 1) Controllable or budget variance 2) Volume or capacity variance The controllable variance is the difference between the actual factory overhead and the budgeted allowance based on the standard capacity attained. The computation of the variance is: Actual factory overhead Budget allowance based on standard hours allowed (4,800 hours): Variable (4,800 hours x P2.00/hour) Fixed Controllable variance

P25,000 P9,600 15,000

24,600 P 400

The budgeted allowance consists of the sum of the variable and the fixed overhead. The budgeted variable overhead for 4,800 hours is derived by multiplying the standard hours by the variable overhead rate of P2.00 per hour. The budget for fixed overhead is obtained from the flexible budget of the Aurora

Corporation. The budgeted fixed overhead remains unchanged at a fixed amount of P15,000 regardless of the changes in volume. The controllable variance is caused by spending and efficiency factors. It is attributable to variable and fixed factory overhead but usually to variable overhead. Volume variance The volume variance is the difference between the budgeted allowance and the overhead applied or charged to the products. The applied overhead is obtained by multiplying the standard hours allowed by the total overhead rate. The computation of the volume variance is given below. Budgeted allowance based on standard hours allowed (see above) Factory overhead applied (4,800 hours x P5.00/hour) Volume variance-unfavorable P24,600 24,000 P 600

The volume variance arises when the standard capacity is not being fully utilized. The variance is unfavorable when the standard capacity is underutilized and it is favorable when the standard capacity is overutilized. The volume variance can be computed more directly as follows: Standard capacity hours Standard hours allowed Unutilized hours Fixed overhead rate per hour Volume variance-unfavorable P5,000 4,800 200 P3 P600

The volume variance is caused only by fixed overhead costs. Hence, only the fixed overhead rate is computing the variance. Three-variance method The overhead variances using this method are: 1) Spending variance 2) Variable efficiency variance 3) Volume variance The spending variance is the difference between the actual factory overhead and the budget allowance based on the actual capacity (hours) attained. The spending variance is computed as follows: Actual factory overhead Budget allowance based on actual hours worked: Variable 4,600 hours x P2 Fixed Spending variance unfavorable P25,000 P9,200 15,000

24,200 P800

The spending variance is caused only by the spending factors. It is not affected by the differences in volume. The variance is the responsibility of the officer who has the authority to purchase or acquire overhead items. The variable efficiency variance is obtained by subtracting by the budget allowance based on the standard hours allowed from the budget allowance based on the actual hours worked. The computation of the variable efficiency variance is shown below. Budget allowance based on actual hours worked P24,200 Budget allowance based on standard hours allowed 24,600 Variable efficiency variance- favorable (P 400) The variable efficiency variance is caused by the difference between actual hours worked and the standard hours allowed. It consists only of the variable factory overhead and can therefore be directly computed as follows: Actual hours worked Standard hours allowed Difference Variable overhead rate Variable efficiency variance 4,600 4,800 ( 200) P2 (P 400)

The variable efficiency variance is due only to efficiency factors, and is the responsibility of the department of the foreman or supervisor who has the authority over the use of overhead. The sum of the spending variance and the variable efficiency variance under the three-variance method is equal to the budget variance under the three-variance method is equal to the budget variance under the two-variance method. The volume variance method under the three variance method is computed in the same manner as the volume variance under the two-variance method. Recapitulation: Spending variance-unfavorable Variable efficiency variance-favorable Volume variance-unfavorable Total overhead variance-unfavorable

P800 (400) 600 P1000

Four-variance method The variances which are computed under this method are the following: 1) Spending variance 2) Variable efficiency variance 3) Fixed efficiency variance 4) Idle capacity variance Under this method, the volume variance is further split into two variances: a fixed efficiency variance and an idle capacity variance.

The computations of the two variances are given below. Actual hours x standard fixed overhead rate (4,600 x P3) Standard hours x standard fixed overhead rate (4,800 x P3) Fixed overhead efficiency variance-favorable Budget allowance based on actual hours Actual hours x standard overhead rate (4,600 x P5) Idle capacity variance unfavorable

P13,800 14,400 (P 600) P24,200 23,200 P 1,200

The sum of the spending variance and the variable efficiency variance under the four variance method is equal to the controllable variance under the two-variance method. The sum of the fixed efficiency variance and the idle capacity variance under the four-variance method is equal to the volume variance under the two variance method. Recapitulation: Spending variance unfavorable Variable efficiency variance favorable Controllable variance Fixed efficiency variance favorable Idle capacity variance Volume variance Total overhead variance unfavorable

P800 (400) P400 (P600) 1,200 600 P1000

Variance computation with work in process It has been assumed thus far that there are no work in process inventories either at the beginning or end of a period. When a process cost system is used and work in process inventories exists, computations of the standard quantities must be based on the equivalent production. To illustrate, assume that the standard cost to produce a unit of product is as follows: Direct materials 5 units @ P10 Direct labor 2 hours @ P20 Factory overhead P40 per hour The production data for a certain month are as follows: Units in process, beginning, 100% complete for material, 40% Complete for conversion costs 2,000 Units started in process 10,000 Units completed 9,000 Units still in process, end, 100% complete for material, 40% Complete for conversion costs 3,000 The computation of the equivalent production depends on the costing method used for inventories. The inventory method used may be first-in, first-out (FIFO) or average costing.

The equivalent production under a FIFO costing method is computed as follows: Materials Conversion costs Completed units 9,000 9,000 Add: work in process, end: Materials 3,000 x 100% 3,000 Conversion costs 2,000 x 40% 1,200 12,000 10,200 Deduct work in process, beginning: Materials 2,000 x 100% 2,000 Conversion costs 2,000 x 60% 1,200 Equivalent production 10,000 9,000 Under an average costing method, the equivalent units of production include work done in previous period. Hence, the equivalent units in the work in process beginning are not deducted. The equivalent units for material and conversion costs would thus be 12,000 and 10,200, respectively. Assuming that a FIFO costing method is used, the standard quantity of materials and labor hours allowed would be: Standard materials quantity allowed 10,000 x 5 units 50,000 units Standard labor hours allowed 9,000 x 2 hours 18,000 hours All variances would be computed using the same procedures previously discussed. Mix variances Mix variances arise in situations where there are two or more classes of materials or labor that are used in the manufacture of a product. Where two or more types of material or labor are used, a standard mix of materials or labor may be established. In such case, a mix variance will result if the actual mix of materials or labor difference from the standard mix. Material mix variance To illustrate the computation of the materials mix variance, assume that a unit of product requires two grades of material: Grade 1 and Grade 2. The standard mix is 3 units of Grade 1 material for every 2units of Grade 2 material. The standard price per unit of Grade 1 is P6.00 and for Grade 2, P4.00. The standard materials mix, prices, and materials cost of a unit of product is given below. Type of material Grade 1 Grade 2 Standard mix 3(60%) 2(40%) 5(100%) Standard price P6 4 Standard cost P18 8 P26

Standard cost per unit of material = P26.00/5 units = P5.20

Assume that during the current year, 2,000 units of product were produced at the following quantities and costs: Grade 1- 6,500 units @ P6 Grade 2- 3,500 units @ P4 10 000 units The materials mix variance is calculated as follows: Actual quantities at actual mix at standard prices: Grade 1 6,500 units x P6 Grade 2 3,500 units x P4 Actual standard quantities at standard mix at standard prices: Grade 1 10,000 units x 60% x P6 P36,000 Grade 2 10,000 units x 40% x P4 16,000 Material mix variance-unfavorable

P39,000 14,000 P53,000

52,000 P 1,000

The actual materials cost is P53,000. The standard materials cost should be P52,000. Thus, there is a materials variance of P1,000, which is unfavorable. The variance was caused by an actual mix that differed from the standard mix. The actual mix was 6,500 units of Grade 1 and 3,500 units of Grade 2. The standard mix should be 6,000 units of Grade 1(10,000 units x 60%, or 2,000 completed units x 3 units of Grade 1) and 4,000 units of Grade 2 (10,000 units x 40% or 2,000 x 2). The mix variances was unfavorable since more units of Grade 1 were used, which is more expensive than the Grade 2 material. The materials mix variance can also be computed as follows: Actual quantities at standard prices (see above) P53,000 Actual quantities at average materials cost (10,000 units x P5.20) 52,000 Materials mix variance unfavorable P1,000 Materials price, usage, and mix variances Assume the same data on standard mix and prices as in the preceding example. The actual operating data for the period were as follows: Materials usage: Grade 1 6,600 units @ P6.00 Grade 2 5,400 units @ P4.50 Actual output 2,000 units The total materials variance is computed as follows: Actual materials cost: \ Grade 1 6,600 units x P6.00 P39,600 Grade 2 5,400 units x P4.50 24,300 P63,900 Standard material costs: Grade 1 2,000 units x 3 x P6 P36,000 Grade 2 2,000 units x 2 x P4 16,000 52,000 Total materials variance unfavorable P11,900

The total materials variance was caused by the following factors. 1) A price for Grade 2 material that was higher than the standard price was higher than the standard price by P0.50 per unit. 2) Total quantity of materials used that exceeded the total standard quantity allowed by 2,000 units. 3) An actual mix that differed from the standard mix. The actual mix was 55% of Grade 1 and 45% of Grade 2. The standard should be 60% of Grade 1 and 40% of Grade 2. The variances caused by these three factors are computed below. Actual quantities at actual prices; Grade 1 6600 units @ P6.00 Grade 2 5400 units @ P4.50 Actual quantities at standard prices: Grade 1 6600 units x P6.00 Grade 2 5400 units x P4.00 Materials price variance unfavorable Or Materials price variance = 5400 units x P0.50 = P 2,700 Actual quantities x standard materials cost (12,000 x P5.20) Standard quantities x standard materials cost (10,000 x P5.20) Materials usage variance unfavorable (2,000 units x P5.20) Actual quantities at actual mix at standard prices: Grade 1 6600 units x P6.00 Grade 2 5400 units x P4.00 Actual quantities at standard mix at standard prices: Grade 1 12,000 x 60% x P6.00 Grade 2 12,000 x 40% x P4.00 Materials mix variance favorable

P39,600 24,300 P63,900 P39,600 21,600

(61,200) P 2,700

P62,400 52,000 P10,400

P39,600 21,600 P61,200 P43,200 19,200

62,400 (P1,200)

Labor mix variance Assume that the manufacture of a unit of product requires two classes of labor. Class A and Class B. the standard labor mix is 3 hours of Class A and also 3 hours of Class B. The standard labor mix for a unit of product is given below. Labor standard mix standard rates standard cost Class A 3 hours (50%) P15 P15 Class B 3 hours (50%) 3 9 6 P24 Standard labor cost per hour = P24.00 / 6 hours = P4.00

During the current period, the following labor hours were worked to produce 2,000 units of product: Class A 5,000 hours @ P5.00 Class B 7,000 hours @ P3.00 There are no labor rates and usage variances since the total labor hours were paid at the standard rates and the total hours worked were equal to the total standard hours allowed. There, is however, a labor mix variance, which can be computed as follows: Actual hours at actual mix at standard rates; Class A 5,000 hours x P5.00 P25,000 Class B 7,000 hours x P3.00 21,000 P46,000 Actual hours at standard mix at standard prices: Class A 12,000 hours x 50% x P5.00 P30,000 Class B 12,000 hours x 50% x P3.00 18,000 48,000 Labor mix variance favorable (P2,000) Labor rate, efficiency, and mix variances Assume in the preceding example that the actual hours worked and the rates paid for the hours to manufacture the 2,000 units were as follows: Class A 5,750 hours @ P6.00 Class B 6,750 hours @ P4.00 The total labor cost variance is computed below. Actual labor cost: Class A 5,750 hours @ P6.00 Class B 6,750 hours @ P4.00 Standard labor cost: Class A 2,000 units x 3 hrs. x P5 Class B 2,000 units x 3 hrs. x P3 Total labor cost variance

P34,500 27,000 P61,500 P30,000 18,000

48,000 P13,500

The total labor cost variance can be accounted for by a labor rate variance, a labor usage variance, and a labor mix variance. The computations of these variances follow. Actual hours x actual rates: Class A 5,750 hours @ P6.00 P34,500 Class B 6,750 hours @ P4.00 27,000 P61,500 Actual hours x standard rates: Class A 5,750 hours @ P5.00 P28,750 Class B 6,750 hours @ P3.00 20,250 49,000 Labor rate variance - unfavorable P12,500

Actual hours x average labor rate (12,500 hours x P4.00) Standard hours x average labor rate (12,000 hours x P4.00) Labor efficiency variance unfavorable Actual hours at standard rates: Class A 5,750 hours x P5.00 Class B 6,750 hours x P3.00 Actual hours at standard cost per hour (12,500 hours x P4.00) Labor mix variance favorable

P50,000 48,000 P 2,000

P28,750 20,250 P49,000 50,000 (P 1,000)

Yield variance Yield is the quantity of finished product resulting from the processing of a given quantity of raw materials. A yield may be computed and expressed in percentage form as follows: Yield percentage = quantity of finished product Quantity of raw materials x 100

A standard yield may be established for a given input of raw materials. When the actual output varies from the expected or standard yield, a yield variance arises. The yield variance can be computed either on the basis of output or on the basis of input. Based on the output, the yield variance is computed as follows: Yield variance = (standard yield actual yield) x standard cost per unit of output In using the above formula, it is necessary to determine the standard output which should result from the actual input. The variance based on input is given by the following formula: Yield variance = (actual input standard input) x standard cost per unit of input In the latter formula, it is necessary to determine the standard input that is allowed for the actual output. Yield variances can be computed for materials, labor, and factory overhead. Labor yield variances result from the quantity and/or quality of materials handled while overhead yield variances result from the greater or lesser number of hours worked. Materials, labor, and overhead yield variances are independent of price or rate variations. They are due only to differences in quantities and are therefore a form of usage variance. Yield variances are computed using the standard prices or rates. Material yield variances Assume that a company produces a product which is sold in 4-liter bottles. Due to losses which occur in the manufacturing process, 5 liters of a liquid are normally required to produce a bottle of the

product. A standard yield of 80% has been established with a standard price per liter of material input of P3.60. During the current month, the business placed in process 32,000 liters of materials at an actual price of P3.60 per liter. The actual output for the month was 24,000 liters. The materials price variance is calculated based on output as follows: Material yield variance = (Standard yield actual yield) x standard material cost per unit of output = (25,600 24,000) x P4.50 = P 7,200 unfavorable The standard output of 25,600 liters is obtained by multiplying the actual input of 32,000 liters by the yield percentage of 80%. The standard material cost per unit of output is computed by dividing the standard material price of P3.60 by 80%. The material yield variance computed on the basis of input gives the same answer: Material yield variance = (actual input standard input) x standard price per unit of input = (32,000 30,000) x P3.60 = P7,200 unfavorable The standard input of 30,000 liters is derived by dividing the actual output of 24,000 by the yield percentage of 80%. Labor yield variance Assume the same facts in the preceding example. Additional data on labor costs are given below. Standard hours hour per liter of material input Standard labor rate P8.00 per hour Actual hours worked 16,000 hours @ P8.00 The labor yield variance is obtained as follows: Based on output: Labor yield variance = (standard output actual output) x standard labor cost per unit of output = (25,600 24,000) x P5.00 = P8.00 unfavorable Standard labor cost = hour x P8.00 per hour 80% = P5.00 per liter Based on input: Labor yield variance = (actual hours standard hours) x standard rate = (16,000 15,000) P8 = P8,000 unfavorable Standard hours = 24,000 liters x hour per liter 80% = 15,000 hours

Budget allowance based on standard hours allowed for actual input (see above) Standard hours allowed for actual input x standard overhead rate (12,000 kg. x 1/5 hr. per kg. x P60) Volume variance favorable Standard hours allowed for actual input x standard overhead rate (see above) Standard hours allowed for actual input x standard overhead rate (9,000 kg. / 80% x 1/5 hr. per kg. x P60) Overhead yield variance - unfavorable

P136,000 144,000 (P 8,000) P144,000 135,000 P 9,000

QUESTIONS: 1. Define standard costs 2. State and distinguish the three types or levels of standards 3. Enumerate some uses of standard costs 4. State the advantages of using a standard cost system in accounting for the cost of products 5. Are standard costs generally accepted for financial reporting purposes 6. What are the two components of a standard cost 7. How are standard overhead costs established? 8. State and differentiate the different concepts of capacity 9. State the various measures in which capacity may be expressed 10. How does a fixed budget differ from a flexible budget? Which type of budget is preferred for a standard cost system? 11. What is meant by the concept of variance? 12. Distinguish variance computation and variance analysis 13. Enumerate the variances from (a) standard material costs, (b) standard labor costs, and (c) standard overhead costs under the two- and three-variance methods 14. State the two methods of computing the materials price variance 15. How does the two-variance method differ from the three-variance method? Which method is theoretically superior? 16. What type of costs gives rise to the following variances: (a) spending variance, (b) variable efficiency variance, (c) volume variance? 17. How is the volume variance computed? 18. How are work in process inventories treated in the computation of the variances? 19. What is a mix variance? How is it computed? 20. What is a yield variance? How is the yield variance determined?

EXERCISES: 1. The Alejandro Co. manufactures a product using a metal plate which has a standard price of P800 per plate. During the month of September, the company purchased 50 metal plates at P820 per plate and 60 metal plates at P790 per plate. Required: Determine the materials quantity variance for the month of September. 2. The standard price of a steel bar used in a finished product is P80 per meter. During October, 9,000 meters of bar were used to produce 1,850 units of finished product. The standard quantity to produce a unit of product is 5 meters. Required: Determine the materials quantity variance 3. The Comfort Furniture Co. manufactures a wooden cabinet which uses 50 board feet of lumber as standard. The standard price per board foot of lumber is P20. During the month of April, the company purchased 4,000 board feet of lumber at P19 and produced 48 cabinets using in the process 2,600 board feet of lumber. Required: a) Determine the materials price variance assuming the variance is computed i. At the time of purchase ii. At the time of usage b) Determine the materials quantity variance 4. During the month of August, the Boado Co. purchased 60,000 units of raw materials at a total cost of P216,000. The actual quantity of materials used was 48,000 units. There was a favorable materials quantity variance of P6,000. According to the standards, 10 units of raw material should be used to produce a unit of product. The actual output during the month was 500 units. Required: a. Calculate the standard price per unit of raw material b. Calculate the standard materials cost per unit of product c. Calculate the materials price variance at the time of purchase 5. The standard time required to produce a unit of product is 15 minutes. The standard rate per hour is P30. During the month of March, 3,600 hours were worked by employees at an average cost of P32 per hour in producing 14,000 units of product. Required: Determine the labor rate and labor efficiency variance.

9) The Doroteo Co. uses a flexible budget in budgeting its overhead expenses. The total factory overhead expenses expected to be incurred at various levels of production are as follows: Units of production Budgeted overhead 14,000 P176,000 16,000 184,000 18,000 192,000 20,000 200,000 The normal capacity of the company is 16,000 units of product. Each unit of product requires two hours of standard productive time. During the month of July, the company produced 19,400 units of product in 37,600 hours. The actual factory overhead was P196,000. Required: 1) Determine the overhead variances under a two-variance method. 2) Determine the overhead variances under a three-variance method. 10) Selected data for a certain company using a standard cost system are given below. Budgeted overhead P360,000 Normal capacity 80,000 hours Actual fixed overhead P354,000 Standard hours allowed 64,000 hours Actual hours worked 70,000 hours Actual output 32,000 units Required: compute the overhead volume variance 11) The budget for overhead of a certain company consists of fixed costs of P120,000 plus P2.50 per direct labor hour. The normal capacity is 80,000 hours per month. The company uses the three-variance method in analyzing overhead variances. The following variances were recorded during a certain month. Unfavorable volume variance P24,000 Unfavorable variable efficiency variance 20,000 Favorable spending variance 12,000 Required: Determine the following: a) The standard hours allowed b) The actual hours worked c) The applied overhead d) The actual overhead

12)

The standard cost to produce a unit of product is as follows: Direct materials 4 units @ P3.00 Direct labor 4 hours @ P4.00 Factory overhead: Variable P5 per hour Fixed P3.00 per hour Standard capacity 4,000 hours Actual data for November Actual output 2,400 units Actual materials purchased 12,000 units @ P2.90 Actual materials used 9,800 units Actual direct labor 4,600 hours @ P4.20 Actual factory overhead P35,000 Required: a) Compute the variances related to materials b) Compute the variances related to direct labor c) Compute the variances related to overhead using the two-variance method

13) The standard output of the Elephant Dress Shop is 240 dresses per month. The standard cost to manufacture a dress is as follows: Direct materials 8 yards @ P35 per yard P280 Direct labor 4 hours @ P25 per hour 100 Factory overhead: Fixed 4 hours @ P12 48 Variable 4 hours @ P8 32 Total P460 Actual data for the month of October: Materials used 1,440 yards P36 Direct labor 800 hours @P28 Actual factory overhead P18,000 Completed production 160 dresses Ending inventory - -32 dresses, fully complete for material and one-half Complete for conversion costs Required: Determine the following variances from standard costs: a) Materials price variance (based on usage) b) Materials quantity variance c) Labor rate variance d) Labor efficiency variance e) Spending variance

f) Variable efficiency variance g) Capacity variance 14) The Carry On Company produces a product which requires the use of two types of material which can be mixed in any proportion. The standard mix and the standard prices of the materials are as follows: Material A 4 kgs. @ P2 Material B 6 kgs. @ P3 During the period , 100 units were produced at the following actual mix and costs: Material A 600 kgs. @ P3.00 Material B 500 kgs. @ P2.50 Determine: a) The materials price variance b) The materials usage variance c) The material mix variance 15) The standard labor cost to produce a product is made up as follows: Class A 3 hours @P20.00 Class B 2 hours @P25.00 During a period, 100 units were produced at the following actual hours and rates: Class A 400 hours @ P20.00 Class B 200 hours @ P24.00 Determine: a) The labor rate variance b) The labor efficiency variance c) The labor mix variance 16) A company produces a single product. The standard yield is 8,000 kilograms of finished output for every 10,000 kilograms of raw material. The standard costs of materials, labor, and overhead are as follows: Material P5 per kg. of raw material input Labor 2 hours per kg. of material input @ P2.00 Factory overhead: Variable P1.00 per hour Fixed P0.50 per hour During a period, 85,000 units of finished product were produced. Actual costs incurred for the month were: Materials 100,000 kgs. @ P50 Labor 200,000 hours @ P20 Overhead P300,000 Determine: a) The material yield variance b) The labor yield variance c) The overhead yield variance

17)

The standard mix to produce a 6,000 units of a product is as follows: Material X 3,000 liters @ P2.00 P6,000 Material Y 1,000 liters @ P4.00 4,000 Total P10,000

During the month of May, 33,000 units of product were produced using the following quantities: Material X 18,000 liters @ P1.95 Material Y - 5,500 liters @ P4.05 Determine: a) The materials price variance b) The materials mix variance c) The materials yield variance 18) Tomelden Co. had budgeted 50,000 units of output using 50,000 units of raw materials at a total materials cost of P100,000. Actual output was 50,000 units of product requiring 45,000 units of raw materials at a cost of P2.10 per unit. The direct material price variance and usage variance were Price P4,500 unfavorable P5,000 favorable P5,000 unfavorable P10,000 favorable Usage P10,000 favorable P10,500 unfavorable P10,500 favorable P 4,500 unfavorable

a) b) c) d)

19) Information on Carino Companys direct material costs for the month of January, 19A follows: Actual quantity purchased 18,000 Actual unit purchase price P3.60 Materials purchase price variance Unfavorable (based on purchases) P3,600 Standard quantity allowed for actual production 16,000 Actual quantity used 15,000 For January, 19A there was a favorable direct material usage variance of a) P3,360 b) P3,375 c) P3,400 d) P3,800 The following processing standards have been set for Domeco Co.s clerical workers Number of hours per 1,000 papers processed 150

20)

Normal number of papers processed per year Wage rate per 1, 000 papers Standard variable cost of processing 1, 5000, 000 papers Fixed costs per year

1,500,000 P600 P900, 000 P150, 000

The following information pertains to the 1, 200, 000 papers that were processed during 19A: Total cost Labor cost Labor hours P915, 000 P760, 000 190, 000

1. For 19A, Domecos expected total cost to process the 1, 200, 000 papers, assuming standard performance, should be a. P910, 000 b. P900, 000 c. P870, 000 d. P840, 000 2. For 19A, Domecos labor rate variance would be a. P40, 000 unfavorable b. P32, 000 favourable c. P10, 000 unfavourable d. P0 AICPA 21. For the month of April, Tuella Co. records disclosed the following data relating to direct labor: Actual cost Rate variance Efficiency variance Standard cost P10, 000 1, 000 1, 500 P9, 500

For the month of April, actual direct labor hours amounted to 2, 900. In April, Tuallas standard direct labor rate per hour was a. P5.50 b. P5.00 c. P4.75 d. P4.50 AICPA 22. The Tamaraw Co. uses a standard cost system. The following information pertains to direct labor Product B for the month of October: Actual rate paid Standard rate Standard hours allowed for P8.40 per hour P8.00 per hour

Actual production Labor efficiency variance What were the actual hours worked? a. 1, 800 b. 1, 810 c. 2, 190 d. 2, 200

2, 000 hours P1, 600 unfavourable

AICPA 23. Union Co. uses a standard cost accounting system. The following overhead costs and production data are available for August, 19A: Standard fixed overhead rate Per direct labor hour Standard variable overhead rate Per direct labor hour Actual direct labor hours worked Standard direct labor hours allowed For actual production Overall overhead variance-favorable The applied factory overhead for August, 19A should be a. P195, 000 b. P197, 000 c. P197, 500 d. P199, 500 AICPA 24. Giron Company uses a standard cost system. For the month of April, 19A, total overhead is budgeted at P80, 000 based on the normal capacity of 20, 000 direct labor hours. At standard each unit of finished product requires 1 direct labor hours. The following data are available for the April, 19A production activity: Equivalent units of product 9, 500 Direct labor hours worked 19, 500 Actual total overhead incurred P79, 500 What amount should Giron credit to the applied factory overhead account for the month of April, 19A? a. b. c. d. P76, 000 P78, 000 P79, 500 P80, 000 AICPA 25. Farol Company uses a flexible budget system and prepared the following information for 19B: Normal Capacity 80% Maximum Capacity 100%

P1.00 P4.00 39, 500 39, 000 P2, 000

Percent of capacity

Direct labor hours Variable factory overhead Fixed factory overhead Total factor overhead Rate per direct labor hour

32, 000 P64, 000 P160, 000 P7

40, 000 P80, 000 P160, 000 P6

Farol operated at 90% of capacity during 19B. The actual factory overhead for 19B was P252, 000. What was the budget (controllable) overhead variance for the year? a. P36, 000 unfavourable b. P20, 000 unfavourable c. P18, 000 unfavourable d. P0 AICPA 26. Based on a monthly normal volume of 50, 000 units (100, 000 direct labor hours). Rafael Co.s standard cost system contains the following overhead costs: Variable P6 per unit Fixed 8 per unit The following information pertains to the month of March, 19A: Units actually produced Actual direct labor hours worked Actual overhead incurred: Variable Fixed

38, 000 80, 000 P250, 000 384, 000

1. For March, 19A, the unfavourable variable overhead spending variance was a. P6, 000 b. P10, 000 c. P12, 000 d. P22, 000 2. For March, 19A, the fixed overhead volume variance was a. 96, 000 unfavourable b. P96, 000 favourable c. P80, 000 unfavourable d. P80, 000 favourable AICPA PROBLEMS 7.1 The Alvarez Co. manufactures a product which has the following standard materials and labor costs: Materials 100 pieces @ P.50 per piece Direct labor 2 hours @ P24. 00 per hour The standard cost for overhead based on a standard production of 2, 500 units per month is as flowers:

Fixed overhead Variable overhead

P20, 000 30, 000

During the month of October, the company produced 2, 200 units at the following actual costs: Direct materials 205, 000 pieces @ P.45 Direct labor 4, 300 hours @ P24.50 Factory overhead: Variable P25, 000 Fixed P27, 000 Required: Determine the variances from standard costs. Use the two and three-variance method for overhead. Raw materials 10 kgs. @ P2.00 per kg. Direct labor 8 hrs. @ P15.00 per hr. Factory overhead: Fixed 30% of direct labor Variable 50% of direct labor Total P20.00 120.00 P36.00 60.00

96.00 P238.00

The standard output per month is 5, 000 units. During February, 3, 600 units were produced. The actual costs for February were as follows: Raw materials used 38, 000 kg. @ P2.10 Direct labor 28, 000 hrs @ P15.20 Factory overhead P440, 000 Required: A variance analysis for materials, labor and factory overhead using the two- and three variance methods for overhead. 7.3 The following data were taken/from the records of the Orig. Inc. at the end of the month of January, 19A: Direct materials: Purchases of materials 380, 000 meters @ 118.00 per 100 meters; 20, 000 meters @ 124 per 100 meters Requisitioned 336, 000 meters Direct labor: Actual hours worked 18, 000 hours @ P18.00 - 6, 000 hours @ P18.75 Actual factory overhead: Variable P132, 000 Fixed P155, 00 Actual output 22, 000 unit The standard costs sheet for the product shows the following costs for materials and labor:

Materials 15 meters @ P120 per 100 meters Direct labor 1 hour @ P18 per hour The standard capacity is 20, 000 labor hours per month. The budget for factory overhead at various levels of the standard capacity as follows: 80% 16, 000 P80, 000 140, 000 P220, 000 90% 18, 000 P90, 000 140, 000 P230. 000 100% 20, 000 P100, 000 140, 000 P240, 000 120% 24, 000 P120, 000 140, 000 P260, 000

Direct labor hours Variable overhead Fixed overhead Total overhead Required: a. b. c. d. e. f. Determine the following: Materials price variance Materials quantity variance Labor rate variance Spending variance Variable efficiency variance Volume variance

7.4 The Sembrano Co. manufactures a single product called Jenna. The company uses a standard cost system in accounting for this product. The standards for direct materials and direct labor have been set as follows: Direct materials 50 pcs. @ P3.00 Direct labor 4 hrs. @ P24... The standard overhead cost is based on a daily production of 400 units for 24 days per month. The overhead rates per hour are as follows: Fixed P.50 per labor hour Variable P1.00 per labor hour During the month of June, the company produced in 26 days 10, 200 units of Jenna. Actual costs incurred were: Direct materials 520, 000 pcs. @ P3.20 Direct labor 40, 500 hours @ P23.50 Factory overhead P112.00 Required: (1) Compute the total materials variance. Analyze the total materials variance. (2) Compute the total labor variance. Analyze the total labor variance. (3) Compute the total overhead variance. Analyze the total overhead variance using the twovariance overhead.

7.5 The Baldomero Co. manufactures a single product. The company uses the standard cost system and the FIFO costing method for inventories. The standard cost to produce a unit of product has been established as follows: Materials 10 kgs. 2 P2.75 Labor 2 hrs. @ P20.00 Factory overhead: Fixed P5.00 per hour Variable P3.00 per hour The standard output per month is 12,000 units. The production and cost data for the month of March are as follows: In process, March 1, one-half complete with respect to materials and conversion costs Started in process In process, March 31, one-third complete with respect to materials and conversion costs Materials purchases 110,000 kgs. 2 P2.80 Materials usage 94,000 kgs. Direct labor 18,500 hours @ P19.50 Factory overhead P165,000 Required: (a) Compute the materials variances. (b) Compute the labor variances. (c) Compute the overhead variances using the two-variance method. 7.6 A company manufactures a chemical product with the following standard costs: Materials 3 kgs. @ P5.00 Labor hour @ P30.00 Factory overhead: Fixed hour @ P20.00 Variable hour @ P8.00 Standard output per month 40,000 units Production and cost data for the month of February are given below. Production (in units): In process, Feb. 1, 40% complete for conversion costs Completed and transferred In process, Feb. 28, 60% complete for conversion costs Costs recorded: Materials purchased 105,000 kgs. @ P5.15

4,000 units 9,000 units 3,000 units

20,000 40,000 10,000

Materials issued 89,000 kgs. Labor 19,400 hours @ P30.40 Factory overhead P536,000 Materials are added at the start of processing. Inventory costing is on a FIFO bass. Required: (1) Determine the equivalent units of production for materials and conversion costs. (2) Determine the following variances: (a) materials price variance (b) materials quantity variance (c) labor rate variance (d) labor efficiency variance (e) spending variance (f) variable efficiency variance (g) volume variance 7.7 The standard costs of manufacturing a unit of product have been set by the Zarate Co. as follows: Direct materials 2 units @ P5.00 per unit Direct labor 3 hrs. @ P8.00 per hr. Factor overhead: Fixed 3 hrs. @ P4.00 per hr. Variable 3 hrs. @ P2.00 per hr. Total P10 24 P12 6

18 P52 -----

The following miscellaneous data are available for the month of September: Favorable materials price variance Unfavorable materials quantity variance Unfavorable labor rate variance Labor efficiency variance Unfavorable spending variance Unfavorable volume variance Actual quantity purchased at standard price Actual quantity used at standard price Required: Determine the following for the month of September: (a) number of units manufactured (b) actual quantity of materials used (c) actual materials price per unit (d) actual labor rate per hour (e) normal capacity hours (f) actual capacity overhead (g) variable efficiency variance under a three-variance method P 15,000 10,000 2,400 None 12,000 24,000 100,000 90,000

7.8

The Feria Manufacturing Co. has established the following standard costs for one of its products:

Direct materials 3 pieces @ P10.00 Direct labor 2 hours @ P12.00

Factory overhead: Fixed 2 hours @ P4.00 Variable 2 hours @ P3.00 The standard capacity of the company is 4,000 units per month. The following variances were recorded for the month March, 19A: Materials price variance (recorded at time of usage) Materials quantity variance Labor rate variance Labor efficiency variance Controllable variance Volume variance Required: Determine the following: (a) the number of units produced (b) the standard cost of materials issued (c) the actual cost of materials issued (d) the actual quantity of materials issued (e) the actual price per unit of material (f) the actual hours worked (g) the actual labor rate per hour (h) the budgeted fixed factory overhead (i) the applied factory overhead (j) the actual factory overhead P3, 000 unfavorable 5, 000 favorable 3, 600 unfavorable 2, 400 unfavorable 1, 000 favorable 4, 000 unfavorable

7.9

The standard materials and labor costs to produce a unit of product are as follows: Materials: Material A 4 kgs. @ P3.30 Material B 4 kgs. @ P2.00 Direct labor: Class A 3 hours @ P6.00 Class B 5 hours @ P4.00 During July, 600 units were produced at the following materials and labor costs: Materials: Material A 2,750 kgs. @ P3.30 Material B 2,250 kgs. @ P1.80 Direct labor: Class A 2,300 hours @ P6.00 Class B 2,300 hours @ P4.40

Required:

Determine the following: (a) materials price variance (b) materials usage variance (c) materials mix variance

(d) labor rate variance (e) labor efficiency variance (f) labor rate variance 7.10 The Ismael Co. produces a product utilizing three grades of material. The standard mix for producing a 50-kg. product is as follows: Material Grade 1 Grade 2 Grade 3 Kilogram 30 18 12 60 --Cost per kilogram P1.40 2.00 3.50 Total_ P 42.00 36.00 42.00 P120.00 ----------

During a certain month, 360,000 kilograms were used in the following proportions and costs: Grade 1 144,000 @ P1.50 Grade 2 126,000 @ P2.20 Grade 3 - 90,000 @ P 3.40 The actual production of finished goods during the year was 5,800 units. Required: 7.11 Determine the materials price, mix, and yield variances.

The Mercedes Co. produces a product which has a standard yield of 80 per cent. The standard cost of materials and labor are: Materials P20.00 per liter Direct labor 2 hours per liter of material input @ P5.00 per hour

During a period, 20,000 liters were put into process. The actual yield was 14,500 liters. Actual direct materials and direct labor costs recorded were: Raw materials 20,000 liters @ P23.00 Direct labor 38,000 hours @ P14.00 Required: Determine the following: (a) materials price variance (b) materials yield variance (c) labor rate variance (d) labor efficiency variance (e) labor yield variance

7.12 The Bentrix Corp. Uses a standard cost accounting system for its single product. The standard materials cost for the production of a 10-kg. unit of product is as follows: Material A 4.8 kg. @ P12.00 Material B 4.2 kg. @ P 5.00 P57.60 21.00

Material C 3.0 kg. @ P 8.00 12.0 kg.

_ 24.00 P102.60

The conversion of 12 kilograms into 10 kilograms of finished product requires 2 hours at a standard rate of P25.00 per hour. Factory overhead is applied at the rate of P10.00 per hour (P6.00 fixed, P4.00 variable). The standard capacity of the plant is 5,000 units per month. The actual operating data for the month of November are: Actual output: 4,750 units Materials purchased: Material A 24,000 kgs. @ P11.25 Material B 20,500 kgs. @ P 5.60 Material C 14,600 kgs. @ P 8.80 Materials used: Material A 23,400 kgs. Material B 19,900 kgs. Material C 14,300 kgs. Direct labor 9,680 hours @ P24.75 Factory overhead: Fixed P62,000 Variable P40,000 Required: Determine the following variances: (a) materials purchase price, mix, and yield variances (b) labor rate, efficiency, and yield variances (c) factory overhead spending, variable efficiency, volume, and yield variances. 7.13 Armando Corporation manufactures a product with the following standard costs: Direct materials 20 yards @ P1.35 per yard Direct labor 4 hours @ P9.00 per hour Factory overhead applied at five-sixths of direct labor. Ratio variable costs to fixed costs: 2 to 1 Total standard cost per unit of output P27 36 30 P93 -----

Standards are based on normal monthly production involving 2,400 direct labor hours (600 units of output). The following information pertains to the month of July, 19A: Direct materials purchased 18,000 yards @ P1.38 per yard Direct materials used 9,500 yards Direct labor 2,100 hours @ P9.15 per hour Actual factory overhead 500 units of the product were actually produced in July, 19A. Required: a. Prepare the following schedules computing:

P24,840 19,215 16,650

1. Variable factory overhead rate per direct labor hour. 2. Total fixed factory overhead based on normal activity. b. Prepare the following schedules for the month of July, 19A. Indicating whether each variance in favourable or unfavorable: 1. Materials price variance (based on purchases). 2. Materials usage variance 3. Labor rate variance 4. Labor efficiency variance 5. Controllable factory overhead variance 6. Capacity (volume) factory overhead variance. AICPA 7.14 At the beginning of 19A, Belarmic Company adopted the following standards: Direct materials Direct labor Factory overhead: Variable Fixed Standard cost per unit 3 lbs. @ P2.50 per lb. 3 hrs. @ 7.50 per hr. P3.00 per direct labor hour P4.00 per direct labor hour P7.50 37.50 15.00 20.00 -------

Normal volume per month is 40, 000 standard labor hours. Belarminos January, Belarmino produced 7, 800 units, with records indicating the following: Direct materials purchased Direct materials used Direct labor Factory overhead 25, 000 lbs.@ P2.60 23, 000 40, 100 hrs. @ P7.30 P300, 000

Required: a. Prepare a schedule of budgeted production costs for January, 19A based on actual production of 7, 800 units. b. For the month of January, 19A, compute the following variances, indicating whether each is favourable: 1. Direct materials price variance, based on purchases. 2. Direct materials usage variance. 3. Direct labor rate variance 4. Direct labor efficiency variance. 5. Factory overhead spending variance. 6. Variable factory overhead efficiency variance 7. Factory overhead volume variance. AICPA 7.15 Wilda & Co. is engaged in the preparation of income tax returns for individuals. Wilda uses the weighted average method and actual costs for financial reporting purposes. However, for internal

reporting, Wilda uses a standard cost system. The standards, based on equivalent performance, have been established as follows: Labor per return 5 hrs. @ P20 per hr Overhead per return 5 hrs. @ P10 per hr. For March, 19A performance, budgeted overhead is P49.00 for the standard labor hours allowed. The following additional information pertains to the month of March, 19A: Inventory data Return in process, March 1 (25% complete) Returns started in March Returns in process, March 31 (80% complete) Actual cost data Returns in process, March 1 Labor Overhead Labor, March 1 to 31 4, 000 hours Overhead, March 1 to 31 Required: a. Using the weighted average method, compute the following for each cost element: (1) Equivalent units of performance. (2) Actual cost per equivalent unit. b. Compute the actual cost of returns in process at March 31. 31. c. Compute the standard cost per return. d. Prepare a schedule for internal reporting analyzing March performance, using the following variances and indicating whether these variances are favorable or unfavorable. (1) (2) (3) (4) (5) (6) Total labor Labor rate Labor efficiency Total overhead Overhead volume Overhead budget AICPA P6, 000 2, 500 200 825

125

89, 000 45, 000

CHAPTER 8 Republic Costs II Standard cost accounting cycle A standard costs accounting cycle is concerned with the determination of the standard costs to manufacture products, the accumulation of these costs in work in process, the transfer of accumulated costs to finished Goods upon the completion of production, and the assignment of the cost of goods sold to a Cost of Goods sold account. The standard cost accounting cycle is shown in the following diagram: Input Raw materials Direct labor Factory overhead Processed Work in process Completed Finished goods Sold Cost of goods sold

Under a pure standard cost system, inventories of raw materials, work in process, and finished goods are carried in and transferred to the various accounts at standard costs. Variances are computed at the time costs are incurred or transferred to the various accounts. Determination of standard costs A standard cost system is a predetermined cost system, in contrast to a historical cost system. The costs of materials, labor, and overhead are determined in advance of production. The standard cost of producing product may be summarized in a standard cost sheet which shows the various quantities and classes of raw materials, labor and factory overhead required producing a unit or a number of units of product. Demonstration problem The following data, which were presented in the preceding chapter, illustrate the accounting procedures under a standard cost system: Standard costs: Direct material 10 units @ P.90 Direct labor 2 hours @ P7.50 Factory overhead: Variable 2 hours @ P2.00 P4.00 Fixed 2 hours @ P3.00 6.00 Total standard cost Actual operating data for current month: Materials purchased 30, 000 units @ P1.00 are reproduced below to

P9.00 15.00

10.00 P34.00 ---------

Materials used 22, 000 units Labor hours worked 4, 600 hours @ P7.75 Actual overhead incurred: Variable P10, 000 Fixed P15, 000 Completed production - 2400 units Recording purchase of materials There are two methods of recording the purchase of materials. The materials may be recorded at standard costs when this procedure is followed, the materials purchase price variance is computed and recorded at the time of purchase. The other method is to record materials at actual costs. Under this procedure, there is no materials price variance recorded at the time of purchase. The materials price variance will be recorded only at the time materials are issued to production. The two methods of recording materials in the Materials inventory account are presented below. Material recorded at standard costs: ____________Materials__________ Standard costs Standard costs (purchase) (Usage)

Materials recorded at actual costs: ____________Materials__________ Actual costs Actual costs (purchase) (Usage) The journal entries to record the purchase of materials under each method are given below. Method I (materials recorded at standard): Materials (30, 000 x P.90) Materials price variance (30, 000 x P.10) Accounts payable (30, 000 x P1.00) Method II (materials recorded at actual): Materials (30, 000 x P1.00) Accounts payable (30, 000 x P1.00) Recording issuance of materials: When materials are issued to the factory, the entry to record the issuance is: Method I: Work in process (24, 000 x P.90) Materials quantity variance (2, 000 x P.90) Materials (22, 000 x P.90) Method II P21, 600 P1, 800 19, 800 P30, 000 P30, 000 P27, 000 3, 000 P30, 000

Work in process (24, 000 x P.90) P21, 600 Materials per usage variance (22, 000 x .10) 2, 200 Materials quantity variance (2, 000 x P.90) P1, 800 Materials inventory (22, 000 x P1) 22, 000 Under the first method, the work in Process account is debited for the standard quantity allowed multiplied by the standard price. The materials inventory account is credited for the actual quantity used multiplied by the standard price. The difference between the debit and credit represents the materials quantity variance. Under the second method, the materials price usage variance and the materials quantity variance are both recognized at the time of usage. The materials price variance recorded applies only to the quantity of materials issued Recording direct labor usage Two entries are required for direct labor: 1) Entry to record the payroll, and 2) Entry to distribute the payroll. The entries are: Payroll Accrued payroll (no payroll deductions Assumed) Work in process (4, 800 x P7.50) Labor rate variance (4, 600 x P.25) Labor efficiency variance (200 x P7.50) Payroll P36, 000 1, 150 P1, 500 35, 650

P35, 650 P35, 650

The first entry records the payroll while the second entry distributes the payroll to Work in Process. The labor variances are recorded at the time labor is charged to production. Recording actual overhead costs The entry to record actual overhead costs incurred is: Factory overhead control Various credits Recording application of overhead costs The entry to apply overhead to the products is: Work in process (4, 800 x P5.00) Factory overhead control

P25, 000 P25, 000

P24, 000 P24, 000

After this entry is posted to the factory overhead control, the account will have a debit balance of P1, 000, which represents the total overhead variance. Recording overhead variances The entry to close the Factory Overhead Control account and to establish the overhead variances under each method is given below.

Two-variance method: Controllable variance Volume variance Factory overhead control Three-variance method: Spending variance Volume variance Variable efficiency variance Factory overhead control Four-variance method: Spending variance Idle capacity variance Variable efficiency variance Fixed efficiency variance Factory overhead control

P400 600 P1, 000 P800 600 P400 1, 000 P800 1, 200 P400 600 1, 000

Recording transfer of completed units The following entry is made to record the transfer of finished products: Finished goods (2, 400 x P34) Work in process P81, 600 P81, 600

The transfer of completed units is made at standard costs since the work in process account has been previously charged at standard costs. Recording sales of completed units When goods are sold, entries are made to record the receipt of cash or the receivable from the customer and the cost of the goods that were sold. The entries are: Cash or Accounts receivable (assumed) Sales Cost of goods sold (at standard) Finished goods P144, 000 P144, 000 P81, 600 P81, 600

Recording mix and yield variances The following entries for mix and yield variances are based on the last example of the preceding chapter: Materials variances: Materials P127, 000 Materials purchase price variance P17, 700 Accounts payable 109, 500 To record purchase of materials. Work in process Materials mix variance Materials To record issuance of materials. P124, 800 2, 400 P127, 200

Finished goods Materials yield variance Work in process To record transfer of materials to finished goods. Labor Variances: Payroll Accrued payroll Work in process Labor rate variance Labor efficiency variance Payroll To record distribution of payroll, Finished goods Labor yield variance Work in process To record actual overhead costs incurred. Overhead variances: Factory overhead control Various credits To record actual overhead costs incurred. Work in process Factory overhead control To record overhead applied to products. Factory overhead control Controllable variance Volume variance To close factory overhead control and set up variances (two-variance method). Finished goods Overhead yield variance Work in process To record transfer of overhead to finished goods.

P117, 000 7, 800 P124, 800

P 63, 000 P 63, 000 P 96, 000 P 9, 000 24, 000 63, 000

P 90, 000 6, 000 P 96, 000

P140, 000 P140, 000 P144, 000 P144, 000 P 4, 000 4, 000 P 8, 000

P135, 000 9, 000 P144, 000

Disposition of variances At the end of an accounting period, the variances may be disposed of using any of the following procedures: 1) Variances may be closed to Cost of Goods Sold 2) Variances may be closed to the Income Summary 3) Variances may be allocated to the inventories and Cost of Goods Sold. In the case of interim statements, the variances may be deferred or carried forward. At the end of the of the accounting year, the deferred variances may be disposed of in any of the three ways cited above.

Chapter 8 Standard Costs II Standard cost accounting cycle A standard costs accounting cycle is concerned with the determination of the standard costs to manufacture products, the accumulation of these costs in work in Process, the transfer of accumulated costs to Finished Goods upon the completion of production, and the assignment of the costs of goods sold to a Cost of Goods Sold account. The standard cost accounting cycle is shown in the following diagram: Input Processed Completed Sold Raw materials Direct labor work in process Finished goods Cost of goods sold Factory overhead Under a pure standard costs system, inventories of raw materials, work in process, and finished goods are carried in and transferred to the various accounts at standard costs. Variances are computed at the time costs incurred or transferred to the various accounts. Determination of standard costs A standard cost system is a predetermined cost system, in contrast to a historical cost system. The cost of materials, labor, and overhead are determined in advance of production. The standard cost of producing a product may be summarized in a standard cost sheet which shows the various quantities and classes of raw materials, labor, and factory overhead required to produce a unit or a number of units of product. Demonstration problem The following data, which were presented in the preceding chapter, are reproduced below to illustrate the accounting procedures under a standard cost system: Standard costs: Direct materials - 10 units @ P.90 Direct labor - 2 hours @7.50 Factory overhead: Variable 2 hours @ P2.00 Fixed-2 hours @ P3.00 Total standard cost Actual operating data for current month: Materials purchased 30,000 units @ P1.00 Material used - 22,000 units Labor hours worked - 4,600 hours @ P7.75 Actual overhead incurred: Variable p10,000 Fixed - P15,000 Completed production - 2,400 units P9.00 15.00 P4.00 6.00 10.00 P34.00

Recording purchase of materials There are two methods of recording the purchase of materials. The materials may be recorded at standard costs. When this procedure is followed, the materials purchase price variance is computed and recorded at the time of purchase. The other method is to record materials at actual costs. Under this procedure, there is no materials price variance recorded at the time of purchase. The materials price variance will be recorded only at the time materials are issued to production. The two methods of recording material in the Materials inventory account are presented below. Materials recorded at standard costs: Materials Standard costs Standard costs (purchase) (usage) Materials recorded at actual costs: Materials Actual costs Actual costs (purchase) (usage) The journal entry to record the purchase of materials under each method are given below. Method I(materials record at standard) : Materials (30,000 x P.90) Materials price variance (30,000 x P.10) Accounts payable (30,000 x P1.00) P27,000 3,000 P30,000

Method II(materials recorded at actual) : Materials(30,000 x P1.00) P30,000 Accounts payable(30,000 x P1.00) P30,000 Recording issuance of materials: When materials are issued to the factory, the entry to record the issuance is: Method I: Work in process(24,000 x P.90) P21,600 Materials quantity variance(2,000 x P.90) P1,800 Materials(22,000 x P.90) 19,800 Method II: Work in process(24,000 x P.90)

P21,600

Materials price usage variance(2,000 x P.10) 2,200 Materials quantity variance (2,000 x P.90) P1,800 Materials inventory(22,000 x P1) 22,000 Under the first method, the work in Process account is debited for the standard quantity allowed multiplied by the standard price. The materials inventory account is credited for the actual quantity used multiplied by the standard price. The difference between the debit and credit represents the materials quantity variance. Under the second method, the materials price usage variance and the materials quantity variance are both recognized at the time of usage. The materials price variance recorded applies only to the quantity of materials issued. Recording direct labor usage Two entries are required for direct labor: 1. Entry to record the payroll, and 2. Entry to distribute the payroll. The entries are: Payroll P35,650 Accrued payroll(no payroll deductions assumed) 1,150 Work in process(4,800 x P7.50) Labor rate variance(4,600 x P.25) Labor efficiency variance(200 x P7.50) Payroll P36,000 1,150 P1,500 36,650

The first entry records the payroll while the second entry distributes the payroll to Work in Process. The labor variances are recorded at the time labor is charged to production. Recording actual overhead costs The entry to record actual overhead costs to the products is: Factory overhead control P25,000 Various credits P25,000 Recording application of overhead costs The entry to apply overhead costs to the procedure is: Work in process(4,800 x P5.00) P24,000 Factory overhead control P24,000 After this entry is posted to the factory Overhead Control, the account will have a debit balance of P1,000, which represents the total overhead variance. Recording overhead variances The entry to close the Factory Overhead Control account and to establish the overhead variances under each method is given below. Two-variance method: Controllable variance

P400

Volume variance Factory overhead control

600 P1,000

Three-variance method: Spending variance P800 Volume variance 600 Variable efficiency variance P400 Fixed efficiency variance 600 Four-variance method: Spending variance P800 Idle capacity variance 1,200 Variable efficiency variance P400 Fixed efficiency variance 600 Factory overhead control 1,000 Recording transfer of completed units The following entry is made of record the transfer of finished products: Finished goods(2,400 x P34) P81,600 Work in process P81,600 The transfer of completed units is made at standard costs since the work in process account has been previously charged at standard costs. Recording sales of completed units When goods are sold, entries are made to record the receipt of cash or the receivable from the customer and the cost of the goods that were sold. The entries are: Cash or accounts receivable(assumed) P144,000 sales P144,000 cost of goods sold(at standard) P81,600 finished goods P81,600 Recording mix and yield variances The following entries for mix and yield variances are based on the last example of the preceding chapter: Materials P127,200 Materials purchase price variances P17,700 Accounts payable 109,500 To record purchase of materials. Work in process P124,800 Materials mix variance 2,400 Materials P127,200 To record issuance materials. Finished goods P117,000

Materials yield variance 7,800 Work in process To record transfer of materials to finished goods.

P124,800

Labor variances: Payroll P63,000 Accrued payroll. P63,000 To record payroll. Work in process P96,000 Labor rate variance 24,000 Labor efficiency variance 9,000 Payroll 63,000 To record distribution of payroll. Finished goods P90,000 Labor yield variance 6,000 Work in process P96,000 To record transfer of labor to finished goods. Overhead variances: Factory overhead control P140,000 Various credits P140,000 To record actual overhead costs incurred. Work in process P144,000 Factory overhead control P144,000 To record overhead applied to products. Factory overhead control P4,000 Controllable variance 4,000 Volume variance P8,000 To close factory overhead control and setup variances (two-variance method). Finished goods P135,000 Overhead yield variance 9,000 Work in process P144,000 To record transfer of overhead to finished goods. Disposition of variances At the end of an accounting period, the variances may be disposed of using any of the following procedures: 1. Variances may be closed to cost of goods sold. 2. Variances may be closed to the income summary. 3. Variances may be allocated to the inventories and cost of goods sold.

In the case of interim statements, the variances ma be deferred or carried forward. At the end of y the accounting year, the deferred variances may be disposed of in any of the three ways cited above. Variances closed to cost of goods sold When variances are closed to cost of goods sold, the cost of goods sold account is debited for the net variance if the net variance is unfavorable and is credited when the net variance is favorable. The entry to close the variances to cost of goods sold is given below. Cost of goods sold Materials quantity variance Materials efficiency variance Materials price variance Labor rate variance Controllable variance Volume variance P 1,850 1,800 1,500 P3,000 1,150 400 600

When variances are closed to cost of goods sold, the variances may be presented as adjustments to the cost of goods sold as standard in the income statement. The presentation of the variance in the income statement is illustrated below. Income statement Sales Cost of goods sold, at standard Add favorable variances: Material price variance Labor rate variance Controllable variance Volume variance Deduct favorable variances: Materials quantity variance Labor efficiency variance Cost of goods sold, at actual Gross profit Selling and administrative expenses Net income P144,000 P81,600 P3,000 1,150 400 600

5,150 P 86,750

P1,800 1,500

3,300 83,450 P60,550 30,000 P30,550

Variances closed to income summary Variances may be closed to the income summary instead of to the cost of the goods sold account. The entry to close the variance would be. Income summary Materials quantity variance P1,850 1,800

Labor efficiency variance Materials price variance Labor rate variance Controllable variance Volume variance

1,500 P3,000 1,150 400 600

The variances may be presented in the income statement in the following manner: Income Statement Sales P144,000 Cost of goods sold, at standard 81,600 Gross profit P62,400 Less selling and administrative 30,000 Net income, at standard P32,400 Add favorable variances: Materials quantity variance P1,800 Labor efficiency variance 1,500 3,300 P35, 700 Deduct unfavorable variances: Materials price variance P3,000 Labors rate variance 1,150 Controllable variance 400 Volume variance 600 5,150 Net income, at actual P30,550 Allocation of variances If standards are not current or attainable, variances are allocated to cost of goods sold and inventories to reflect actual costs. To illustrate, assume the following variances, which are all unfavorable: Materials price variance P30,000 Labor efficiency variance 20,000 Overhead volume variance 15,000 The percentage of materials, labor, and overhead in inventories and cost of goods sold are given below. Materials Labor Overhead Amount % Amount % Amount % Total Materials P100,000 25 P100,000 Work in process 40,000 10 P17,500 10 P12,500 10 70,000 Finished goods 80,000 20 61,250 35 52,500 42 193,750 Cost of sales 180,000 45 96,250 55 60,000 48 336,250 P400,000 100 P175,000 100 125,000 100 P700,000 The allocation of variances based on the percentage of cost elements is presented below. Materials work in process finished goods cost of sold goods total Materials price variance P7,500 P3,000 P6,000 P13,500 P30,000 Labor efficiency variance 2,000 7,000 11,000 20,000

Overhead volume variance P7,500

1,500 P6,500

6,300 P19,300

7,200 P31,700

15,000 P65,000

The cost of materials, work in process, finished goods, and cost of goods sold after allocation are: Materials work in process finished goods cost of goods sold Standard cost before allocation P100,000 P70,000 P193,750 P336,250 Allocation of variances 7,500 6,500 19,300 31,700 Actual costs P107,500 P76,500 P213,050 P367,950 Variance analysis Variance analysis is concerned with the determination of the cause of variances. It is also concerned with pinpointing responsibility for the variances. The investigation of the cause variances is necessary to the proper control of costs. Based on this investigation, persons who have responsibility for certain costs can take appropriate action to correct the variances. Analysis of materials variances Some of the cause of unfavorable materials price variances are: 1. Increase in prices of materials 2. Inefficiency of the purchasing department 3. Higher delivery costs 4. Emergency purchase of materials 5. Substitution of materials Price variances are the responsibility of the purchasing officer or department. However, unfavorable price variances may also be caused by changes in production schedules, rush orders, or others factors beyond the control of the purchasing officer. Materials quantity variances may be due to such causes as the following: 1. Careless materials handling 2. Poor machinery 3. Inexperienced workers 4. Pilferage 5. Excessive spoilage 6. Changes in production specifications or quality control procedures 7. Substandard materials. Responsibility for materials quantity variances usually rests with the foreman, supervisors, or production manager. Variances due to substandard materials may be the responsibity of purchasing officer. Analysis of labor variances

Labor rate variances may be due to the following causes: 1. Labor rate or wage increase 2. Substitution of higher paid labor for lower paid labor 3. Use of an average rate for several types of labor

Labor efficiency variances may be attributable to the following: 1. Substandard materials 2. Production bottlenecks or stoppages 3. Changes in machinery, layout, or quality control standards 4. Faulty equipment 5. Lack of proper equipment maintenance 6. Poor supervision 7. Faulty instructions 8. Changes in efficiency of employees due to personal, family, or financial problems The responsibility for labor variances lies with the supervisors who are responsible for the use of labor. Analysis of overhead variance Controllable or budget variances may result from the following: 1. Increase in the prices of indirect materials and supplies 2. Change in wage rates, power rates, tax rates, depreciation rates, premium rates, etc. 3. Acquisition or disposal of plant assets 4. Changes in depreciation methods 5. Consumption of quantities in greater than standard quantities The person responsible for the controllable variance is the department or production manager. Higher prices or wage rates, however, may be beyond the control of the department head or manager. Capacity variances may be due to the following factors: 1. Poor business conditions 2. Poor sales demand 3. Strikes 4. Shortage of material 5. Weather 6. Inadequate or poor marketing practices 7. Poor quality of products 8. Machine breakdown 9. Absenteeism Capacity variances are the responsibility or higher management. Some factors causing capacity variances, variances, however, may be beyond the control of management. Reporting variances Control of costs is made possible by the use of performance cost responsibility reports. These reports serve two basic purpose:

1. To provide a basis for corrective action, and 2. To provide a basis for evaluating or appraising performance. To attain these objectives, certain basic principles of reporting have to be observed. These include the following:

1. Reports must be addressed to the proper persons. These are the persons who have the authority to take corrective action. 2. Reports must be include only the relevant information 3. Reports must be submitted or prepared on time. Reports maybe prepared daily, weekly, or monthly depending upon the need of the managers for certain types of information. An illustration of a performance or cost responsibility report showing variances from budgeted costs is presented below. XYZ Corporation Budget Materials Direct labor Supplies Indirect labor Depreciation Repairs and maintenance Power Insurance Taxes P18,000 12,300 4,000 5,600 3,000 4,400 2,700 1,800 3,400 P55,200

Actual P 18,600 12,500 4,500 5,700 3,000 4,200 2,400 1,800 3,500 P56,200

variable unfavorable(Favorable) P600 200 500 100 0 (200) (300) 0 100 P1,000

QUESTIONS: 1. State the procedures involved in a standard cost accounting cycle. 2. What is the standard cost sheet? 3. How are the inventories of raw materials, work in process, and finished goods carried in a standard cost system? 4. State briefly the accounting procedures for materials, labor, and factory overhead in the standard cost system? 5. a) How is an unfavorable variance recorded? b) How is a favorable variance recorded? 6. What is meant by variance analysis? 7. Is an unfavorable variance necessarily bad? 8. Is it required that all variances from standard costs be investigated?

9. State some causes of each of the following variances: materials price, materials quantity, labor rate, labor efficiency, overhead budget, and overhead variance/ 10. State the various methods of disposing variances. 11. What is the rationale for the use of each method of disposing variances? 12. Which method of disposing variances yields the same results as actual or conventional costing? 13. When should standards be revised? EXERCISES 1. During a certain month, a company purchased 60,000 units of material at a unit cost of P2.40. During the same month, the company produced 25,000 units of product using 49,200 units of raw materials. The standard price per unit of material is P2.30 and each unit of product requires two units of material. Required: a) Prepare the journal entry to record the purchase of raw materials assuming that materials are carried at standard costs. b) Prepare the journal entry to record issuance of raw materials. 2. The payroll of a company for the month of July was P354,000. The actual hours worked during the month were 12,000 hours at a rate of P29.50 per hour. The company produced 23,500 units of product during the month standards reveal that 2 units of product should be manufactured each hour at a standard rate of P30.00 per hour. Required: Prepare the entries to record and distribute the payroll for the month of July. 3. The standard capacity of a company is 20,000 units of product per month. Each unit of product requires 4 hours of processing time. Factory overhead at standard capacity has been budgeted at P80,000 fixed overhead and P100,000 variable overhead. During the current year, the company produced 19,800 units in 79,600 hours. Actual overhead costs incurred were: fixed, P82,000; variable, P95,200. Required: Prepare all journal entries related to factory overhead under (a) a two-variance method, and (b) a three-variance method. 4. The Achilles Manufacturing Co. manufactures a product with the following standard materials mix: Material A 3 sq. ft. @ P16.00 Material B 5 sq. ft. @ P24.00 P48.00 120.00 P168.00

During the month of August, the company produced 500 units of product. Materials purchased and issued were: Purchases: Material A 2,000 sq. ft. @ P17.00 Material B 3,000 sq. ft. @ P25.00

Issues: Material A 1,600 sq. ft. Material B 2,400 sq. ft. Required: Prepare the journal entries to record (a) the purchase of materials, and (b) the issue of materials. 5. A company applies factory overhead on the basis of direct labor hours. The time required to produce a unit of product is 2 hours. The standard capacity is 8,000 hours per month. During a certain month, 4,500 units were produced. The following costs and variances were recorded: Actual factory overhead P140,000 Controllable variance 10,000 (debit) Volume variance 5,000 (credit) Required: Determine the following: a) Factory overhead applied b) Total overhead rate per hour c) Budgeted fixed overhead costs 6. A company recorded an unfavorable materials price variance at the time of purchase of P24,000. An analysis of the records at the end of the period shows the following materials contents of the following accounts: Work in process 24,000 kgs. Finished goods 18,000 kgs. Cost of goods sold 30,000 kgs. Materials still on hand at the end of the period total 48,000 kgs. Required: Prepare the journal entry to allocate the materials price variance to the inventory and cost of goods sold accounts. 7. The Galarce Co. records materials at standard costs. The standard cost per unit of material is P5.00. During the month of October, the company purchased 18,000 units of material at a total cost of P93,600. Materials issued during the month totaled 12,000 units. The standard called for the use of 10,000 units of material. Actual production during the month during the month of October was 5,000 units. Units sold during the month were 4,000 units. Required: Prepare journal entries to record (a) the purchase of materials, (b) the issuance of materials, and (c) the allocation of the materials variances to cost of sales and inventories. 8. The standard cost of producing a unit of product of the Conrado Co. is P40.00 per unit. The unit selling price is P60.00 During the month of September, the company produced 15,000 units and sold 12,000 units of product. The variances recorded during the month were as follows:

Materials price variance Materials quantity variance P4,500 Labor rate variance 3,600 Labor efficiency variance 2,200 Overhead volume variance 1,500 Selling and administrative expenses for the month were P160,000. Required: Prepare a condensed income statement for the month ended September 30 assuming that all variances are closed to the income account. 9. Orlando Co. has underapplied overhead of P45,000 for the year ended December 31, 19A. Before disposition of the underapplied overhead, selected December 31, 19A balances from Orlandos accounting records are as follows: Sales P1,200,000 Cost of goods sold 720,000 Inventories: Direct materials 36,000 Work in process 54,000 Finished goods 90,000 Under Orlandos cost accounting system, over or underapplied overhead is allocated to appropriate inventories and cost of goods sold based on year-end balances. In its 19A income statement, Orlando should report cost of goods sold of a. P682,000 b. P684,000 c. P756,000 d. P757,500 PROBLEMS 8.1

Debit P6,400

Credit

The Estella Co. produces a single product having the following standard costs: Materials 1 cu. ft. @ P50.00 P50.00 Direct labor hour @ P24.00 12.00 Factory overhead: Fixed hour @ P6.00 3.00 Variable hour @ P10.00 5.00 Total standard cost per unit P70.00 Normal capacity Actual data for February Production Materials purchased Materials used 5,000 units

4,500 units 4,800 cu. ft. @ P49.00 4,600 cu. ft.

Direct labor Factory overhead Sales

2,300 hours @ P24.50 P35,000 4,200 units @ P120.00

8.2

Required: Prepare all journal entries to record the above transactions using a twovariance method for overhead. A standard cost sheet for one of the products of the Arsenio Company shows the following: Direct materials 12 units @ P4 P48 Direct labor hour @ P40 20 Factory overhead (based on direct labor hours): Fixed 9 Variable 6 Standard cost per unit P83 The following transactions occurred during March: Manufactured 7,600 units of product. Purchased 94,000 units of raw materials at a total cost of P357,200. Issued 89,000 units of raw materials for use in production. Paid P163,800 for 3,900 hours worked during the month (assume no payroll deductions). 5) Actual factory overhead recorded was P126,000 6) Applied P114,000 of factory overhead to production using a rate on a standard production of 8,000 units. Required: 1) Determine the following variances: (a) Materials price variance (b) Materials quantity variance (c) Labor rate variance (d) Labor efficiency variance (e) Spending variance (f) Variable efficiency variance (g) Capacity variance 2) Prepare journal entries to record the following: (a) Purchase of material (b) Issue of material (c) Payroll (d) Distribution of payroll (e) Actual factory overhead incurred (f) Applied factory overhead (g) Transfer of completed production to Finished Goods (h) Closing of Factory Overhead Control 1) 2) 3) 4)

8.3

The Lorenzo Manufacturing Co. uses a standard cost accounting system for its only product. The standard cost to manufacture a unit of product has been established as follows: Materials 6 units @ P2.00 P12 Direct labor 2 hours @ P10.00 per hour 20 Factory overhead 2 hours @ P5.00 10 Total standard cost per unit P42 The fixed overhead based on standard capacity of 10,000 units is P40,000 per month. Actual operations during the month of September were as follows: Production (in units): Started in process 10,000 Completed 9,000 In process, Sept. 30, all materials converted 1,000 Cost recorded: Direct materials used 62,000 units P136,400 Direct labor 18,500 hours 194,250 Factory overhead 98,000 Actual sales (in units) 8,000 Required: Prepare journal entries to record the following: (a) Issue of materials (materials inventory are recorded at actual cost) (b) Distribution of payroll (c) Applied factory overhead (d) Completed production (e) Cost of sales (f) Closing of Factory Overhead Control account 8.4 The standard mix and standard prices of materials to produce a 100-kg. unit of product are as follows: Material A 40 kg. @ P0.50 Material B 40 kg. @ P0.30 Material C 30 kg. @ P0.60 During April, the following materials quantities were purchased: Material A 290,000 kg. @ P0.45 Material B 310,000 kg. @ P0.35 Material C 250,000 kg. @ P0.65 The materials purchase price variance is recorded at the time of purchase. Actual production during the month was 7,000 units of product. The following quantities of materials were used: Material A 278,500 kg. Material B 282,000 kg. Material C 215,000 kg.

Required: Prepare the journal entries for the following: (a) Purchase of materials (b) Usage of materials (c) Completion of materials (transfer to Finished Goods) 8.5 The Calderon Manufacturing Co. uses a standard cost system for one of its products. The standard cost system for one of its product are as follows: Direct materials 4 units @ P5.00 Direct labor 2 hours @ P18.00 Factory overhead: Variable P4.00 per hour Fixed P6.00 per hour The actual production for the month of May was 7,000 units. Variances recorded for the month were as follows: Debit Credit Materials price variance P3,000 Materials usage variance P2,500 Labor rate variance 7,100 Labor efficiency variance 3,600 Overhead controllable variance 2,000 Overhead volume variance 6,000 Required: Determine the following: (a) The standard cost of actual materials issued (b) Amount of direct labor hours worked in May (c) Actual labor rate per hour (d) Actual factory overhead (e) Budgeted fixed overhead (f) Standard capacity The Everlasting Corporation uses a standard cost system to account for the cost of its single product. The standard cost per unit of product consists of the following: Raw materials 6 units @ P4 P24 Direct labor hour @ P30 15 Factory overhead: Fixed hour @ P10 5 Variable hour @ P20 10 Total standard cost P54 The fixed overhead rate is based on a standard capacity of 3,000 hours per month. Data for the month of November are as follows: Units produced 6,000 units Units sold 4,000 units Raw materials 38,000 units

8.6

The following variances were recorded for the same month: Materials price variance P7,600 ( debit) Materials usage variance 8,000 (debit) Labor rate variance 5,700 (debit) Labor efficiency variance 3,000 (credit) Overhead controllable variance 4,200 (debit) Overhead volume variance None The materials inventory variance is carried at actual cost. Required: (a) Prepare journal entries to record the following: (1) issue of material, (2) distribution of payroll, (3) application of overhead, (4) completion of production, (5) cost of sales, (6) closing of Factory Overhead Control (b) Prepare entries to allocate the variances to inventories and cost of sales 8.7 The Benedicto Co. uses a standard cost system for its product which sells for P30 per unit. The standard cost of producing one unit of product is as follows: Materials 5 pieces @ P1.00 P5.00 Direct labor 1 hour @ P9.00 9.00 Factory overhead: Fixed 1 hour @ P4.00 4.00 Variable 1 hour @ P 2.00 2.00 Total standard cost P20.00 The standard capacity of the company has been established at 50,000 units per year. During 19D, the company produced 48,000 units of product and sold 45,000 units. The following costs and expenses were incurred: Direct materials used 243,000 pieces @ P0.95 Direct labor 49,600 hours @ P9.20 Factory overhead: Fixed P200,000 Variable P94,000 Selling expenses P135,000 Administrative expenses P182,000 The company records raw materials at standard costs and uses the three-variance method for analyzing overhead. Required: Prepare an income statement for the year ended December 31, 19D. Assume that all variances are due to controllable causes and are written off as losses. 8.8 The Bravo Co. employs a standard costs system for its product called Denden. The standard materials and labor costs per unit of Denden are:

Materials 15 kgs. @ P2.00 Labor 3 hours @ P12.00

P30.00 36.00

The factory overhead at a standard capacity of 9,000 hours per month has been budgeted as follows: Fixed P54,000 Variable P45,000 Operating data for the year ended December 31, 19C are summarized as follows: Production 3,200 units Sales 2,800 units @ P120.00 per unit Materials purchased 50,000 units @ P2.05 Materials issued 47,500 units Labor 9,500 hours @ P11.75 Factory overhead P112,000 Selling and administrative expenses - `P36,000 The materials are recorded at standard costs. The company uses the two-variance method for analyzing overhead variances. Required: Prepare an income statement for the year ended December 31, 19C. Assume that the company allocates all variances from standard cost over inventories and cost of sales.