Accounting- ATC 14-1 (Pg. 686) 1. (Follow the cash) In a narrative format,

| January 30, 2017

Question
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CHAPTER 1

B
R
O
O
K
S
L
E
LEARNING OBJECTIVES
N
T
After you have mastered the material in this chapter, you will be able to:
Z
1 Distinguish between managerial and financial accounting.
2 Identify the cost components of a product made by,a manufacturing company: the cost of materials, labor,

Management Accounting
and Corporate Governance

and overhead.

3
4
5
6
7
8

Explain the effects on financial statements of product costs versus general, selling, and administrative costs.
B
Distinguish product costs from upstream and downstream costs.
R
Explain how product costing differs in service, merchandising, and manufacturing companies.
I
Show how just-in-time inventory can increase profitability.
D

G
Identify the key components of corporate governance.
I
Identify emerging trends in accounting (Appendix A).
T

CHAPTER OPENING

2

Andy Grove, Senior Advisor to Executive Management of Intel Corporation, is credited with the motto “Only the
0
paranoid survive.” Mr. Grove describes a wide variety of concerns that make him paranoid. Specifically, he declares:

4

I worry about products getting screwed up, and I worry about products getting introduced prematurely. I
4
worry about factories not performing well, and I worry about having too many factories. I worry about hiring
B
the right people, and I worry about morale slacking off. And, of course, I worry about competitors. I worry
about other people figuring out how to do what we do better or cheaper, and displacing us with our customers.
U
Do Intel’s historically-based financial statements contain the information Mr. Grove needs? No. Financial accounting
is not designed to satisfy all the information needs of business managers. Its scope is limited to the needs of external
users such as investors and creditors. The field of accounting designed to meet the needs of internal users is called
managerial accounting.
2

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The Curious Accountant
In the first course of accounting, you learned how
retailers, such as Sears, account for the cost of equip- B
ment that lasts more than one year. Recall that the R
equipment was recorded as an asset when purchased, O
and then it was depreciated over its expected useful O
life. The depreciation charge reduced the company’s K
assets and increased its expenses. This approach was S
justified under the matching principle, which seeks to –

L
E
the cost (resource) is used to generate revenue.
N
Is depreciation always shown as an expense on
T
the income statement? The answer may surprise you.
Z
Consider the following scenario. Schwinn manufactures
,
recognize costs as expenses in the same period that

the bicycles that it sells to Sears. In order to produce the
bicycles, Schwinn had to purchase a robotic machine

B
R
Do you think Schwinn should account for depreciation on its manufacturing equipment the same way Sears
I
accounts for depreciation on its registers at the checkout counters? If not, how should Schwinn account for its
D
depreciation? Remember the matching principle when thinking of your answer. (Answer on page 12.)
G
I
T
that it expects can be used to produce 50,000 bicycles.

2
0
4
4
B
U

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Chapter 1

DIFFERENCES BETWEEN MANAGERIAL
AND FINANCIAL ACCOUNTING

Users and Types of Information
Financial accounting provides information used primarily by investors, creditors, and
others outside a business. In contrast, managerial accounting focuses on information
used by executives, managers, and employees who work inside the business. These two
B
user groups need different types of information.
Internal users need information to plan, direct, and control business operations. The
R
nature of information needed is related to an employee’s job level. Lower level emO
ployees use nonfinancial information such as work schedules, store hours, and customer
service policies. Moving up the organizational ladder, financial information becomes
O
increasingly important. Middle managers use a blend of financial and nonfinancial
K
information, while senior executives concentrate on financial data. To a lesser degree,
S
senior executives also use general economic data and nonfinancial operating information.
For example, an executive may consider the growth rate of the economy before deciding
to expand the company’s workforce.
L
External users (investors and creditors) have greater needs for general economic
information than do internal users. For example, an investor debating whether to purE
chase stock versus bond securities might be more interested in government tax policy
N
than financial statement data. Exhibit 1.1 summarizes the information needs of different user groups.
T

Z

Level of Aggregation ,

External users generally desire global information that reflects the performance of a company as a whole. For example, an investor is not so much interested in the performance of
a particular Sears store as she is in the performance of Sears Roebuck Company versus
B
that of JC Penney Company. In contrast, internal users focus on detailed information
R
about specific subunits of the company. To meet the needs of the different user groups,
I
financial accounting data are more aggregated than managerial accounting data.

D
G
I
EXHIBIT 1.1
T
Relationship Between Type of User and Type of Information
Economic data
Outsiders

Distinguish between managerial
and financial accounting.

While the information needs of internal and external users overlap, the needs of
managers generally differ from those of investors or creditors. Some distinguishing
characteristics are discussed in the following section.

Insiders

LO 1

2
Investors and creditors 0
4
4
B
U

Financial data

Nonfinancial data

Senior executives

Middle managers

Operating employees

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Management Accounting and Corporate Governance

Regulation
Financial accounting is designed to generate information for the general
public. In an effort to protect the public interest, Congress established the
Securities and Exchange Commission (SEC) and gave it authority to
regulate public financial reporting practices. The SEC has delegated much
of its authority for developing accounting rules to the private sector
Financial Accounting Standards Board (FASB), thereby allowing the
accounting profession considerable influence over financial accounting
reports. The FASB supports a broad base of pronouncements and practices known as generally accepted accounting principles (GAAP). GAAP
severely restricts the accounting procedures and practices permitted in
published financial statements.
B
Beyond financial statement data, much of the information generated by manageR
ment accounting systems is proprietary information not available to the public. Since
this information is not distributed to the public, it need not be regulated to protect
O
the public interest. Management accounting is restricted only by the value-added
O
principle. Management accountants are free to engage in any information gathering
K
and reporting activity so long as the activity adds value in excess of its cost. For
example, management accountants are free to provide forecasted information to
S
internal users. In contrast, financial accounting as prescribed by GAAP does not
permit forecasting.

L
E
While financial accounting is characterized by its objectivity, reliability, consistency,
and historical nature, managerial accounting is more N
concerned with relevance and
timeliness. Managerial accounting uses more estimatesT fewer facts than financial
and
accounting. Financial accounting reports what happened yesterday; managerial
Z
accounting reports what is expected to happen tomorrow.
,
Information Characteristics

Time Horizon and Reporting Frequency
Financial accounting information is reported periodically, normally at the end of a
B
year. Management cannot wait until the end of the year to discover problems. PlanR
ning, controlling, and directing require immediate attention. Managerial accounting
information is delivered on a continuous basis.
I
Exhibit 1.2 summarizes significant differences between financial and managerial
D
accounting.

G
I
PRODUCT COSTING IN MANUFACTURING
T
COMPANIES
A major focus for managerial accountants is determining product cost.1 Managers need
2
to know the cost of their products for a variety of reasons. For example, cost-plus
is
pricing is a common business practice.2 Product costing 0 also used to control business
operations. It is useful in answering questions such as: Are costs higher or lower than
4
expected? Who is responsible for the variances between expected and actual costs?
What actions can be taken to control the variances?
4

B
U
A company normally incurs three types of costs when making products. Specifically,
Components of Product Cost

the company must pay for (1) the materials used to make the products, (2) the labor
1

This text uses the term product in a generic sense to mean both goods and services.
Other pricing strategies will be introduced in subsequent chapters.

2

LO 2
Identify the cost components of a
product made by a manufacturing
company: the cost of materials,
labor, and overhead.

5

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Chapter 1

EXHIBIT 1.2
Comparative Features of Managerial versus Financial Accounting Information
Features

Managerial Accounting

Financial Accounting

Users

Insiders including executives,
managers, and operators

Information type

Economic and physical data
as well as financial data
Local information on subunits
B
of the organization
R
No regulation, limited only by
the
O value-added principle
Estimates that promote
O
relevance and enable
timeliness
K

Outsiders including investors,
creditors, government
agencies, analysts, and
reporters
Financial data

Level of aggregation
Regulation
Information characteristics

Time horizon
Reporting frequency

S

Past, present, and future
Continuous reporting

Global information on the
company as a whole
Regulation by SEC, FASB, and
other determiners of GAAP
Factual information that is
characterized by objectivity,
reliability, consistency, and
accuracy
Past only, historically based
Delayed with emphasis on
annual reports

L
E
N
expended by the employees who transform the materials into products, and (3) the
overhead (other resources suchT utilities and equipment consumed in the process of
as
making the products). If the company stores its products, the costs of the materials,
Z
labor, and overhead used in making the products are maintained in an inventory
account until the products are ,sold. For a detailed explanation of how product costs
flow through the financial statements, refer to the following example of Tabor Manufacturing Company.

B
R
Tabor Manufacturing Company
Tabor Manufacturing Company makes wooden tables. The company spent $1,000 cash
I
to build four tables: $390 for materials, $470 for a carpenter’s labor, and $140 for
D
tools used in making the tables. How much is Tabor’s expense? The answer is zero. The
G
$1,000 cash has been converted into products (four tables). The cash payments for
materials, labor, and tools (overhead) were asset exchange transactions. One asset (cash)
I
decreased while another asset (tables) increased. Tabor will not recognize any expense
T
until the tables are sold; in the meantime, the cost of the tables is held in an asset
account called Finished Goods Inventory. Exhibit 1.3 illustrates how cash is transformed
into inventory.

2
Average Cost per Unit 0
4
How much did each table made by Tabor cost? The actual cost of each of the four
tables likely differs. The carpenter probably spent a little more time on some of the tables
4
than others. Material and tool usage probably varied from table to table. Determining
B
the exact cost of each table is virtually impossible. Minute details such as a second of
labor time cannot be effectively U
measured. Even if Tabor could determine the exact cost
of each table, the information would be of little use. Minor differences in the cost per
table would make no difference in pricing or other decisions management needs to
make. Accountants therefore normally calculate cost per unit as an average. In the case
of Tabor Manufacturing, the average cost per table is $250 ($1,000 4 4 units). Unless
otherwise stated, assume cost per unit means average cost per unit.

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Management Accounting and Corporate Governance

EXHIBIT 1.3
Transforming the Asset Cash Into the Asset Finished Goods Inventory
Financial assets

Manufacturing process

Physical assets

$390 materials

Converted

Converted

B
$470 labor
R
O
O
$1,000 of
finished goods
K
$140 overhead
S
L
E
CHECK YOURSELF 1.1
N
All boxes of General Mills’ Total Raisin Bran cereal are priced at exactly the same amount in
your local grocery store. Does this mean that the actual cost ofT
making each box of cereal was
exactly the same?
Z
,
Answer No, making each box would not cost exactly the same amount. For example, some
$1,000 of
cash

boxes contain slightly more or less cereal than other boxes. Accordingly, some boxes cost
slightly more or less to make than others do. General Mills uses average cost rather than
B
actual cost to develop its pricing strategy.

R
I
D
Costs Can Be Assets or Expenses
G
It might seem odd that wages paid to production workers are recorded as inventory
instead of being expensed. Remember, however, that expenses are assets used in the
I
process of earning revenue. The cash paid to production workers is not used to produce
T
revenue. Instead, the cash is used to produce inventory. Revenue will be earned when
the inventory is used (sold). So long as the inventory remains on hand, all product costs
(materials, labor, and overhead) remain in an inventory account.
When a table is sold, the average cost of the table is 2
transferred from the Inventory
account to the Cost of Goods Sold (expense) account.0 some tables remain unsold
If
at the end of the accounting period, part of the product costs is reported as an asset
4
(inventory) on the balance sheet while the other part is reported as an expense (cost of
goods sold) on the income statement.
4
Costs that are not classified as product costs are normally expensed in the period
B
in which they are incurred. These costs include general operating costs, selling and
administrative costs, interest costs, and the cost of income taxes.
U
To illustrate, return to the Tabor Manufacturing example. Recall that Tabor made
four tables at an average cost per unit of $250. Assume Tabor pays an employee who
sells three of the tables a $200 sales commission. The sales commission is expensed
immediately. The total product cost for the three tables (3 tables 3 $250 each 5 $750)
is expensed on the income statement as cost of goods sold. The portion of the total

7

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Chapter 1

EXHIBIT 1.4
Cost Classification for Tabor Manufacturing Company
Cost category

Balance sheet
$1,000
Cost of finished
goods

$1,000
Product cost
• Materials
• Labor
• Overhead (tools)

Income statement
$750
(Products sold)
Cost of goods sold

B $250
R (Products not sold)
Ending inventory
O
O
K
$200
$200
General, selling,
Selling and
S
and administrative
administrative
expense
costs
L
E
product cost remaining in inventory is $250 (1 table 3 $250). Exhibit 1.4 shows the
N
relationship between the costs incurred and the expenses recognized for Tabor ManuT
facturing Company.
Z
Effect of Product Costs, on Financial Statements
LO 3
Explain the effects on financial
statements of product costs versus
general, selling, and administrative
costs.

We illustrate accounting for product costs in manufacturing companies with Patillo
Manufacturing Company, a producer of ceramic pottery. Patillo, started on January 1,
2013, experienced the following accounting events during its first year of operations. 3
B
Assume that all transactions except 6, 8, and 10 are cash transactions.

R

1. Acquired $15,000 cash by issuing common stock.
I
2. Paid $2,000 for materials that were used to make products. All products started
were completed during the D
period.
G
3. Paid $1,200 for salaries of selling and administrative employees.
4. Paid $3,000 for wages of production workers.
I
5. Paid $2,800 for furniture used in selling and administrative offices.
T
6. Recognized depreciation on the office furniture purchased in Event 5. The furniture
was acquired on January 1, had a $400 estimated salvage value, and a four-year useful life. The annual depreciation charge is $600 [($2,800 2 $400) 4 4].
2
7. Paid $4,500 for manufacturing equipment.
0
8. Recognized depreciation on the equipment purchased in Event 7. The equipment
4
was acquired on January 1, had a $1,500 estimated salvage value, and a three-year
4
useful life. The annual depreciation charge is $1,000 [($4,500 2 $1,500) 4 3].
9. Sold inventory to customers for $7,500 cash.
B
10. The inventory sold in Event 9 cost $4,000 to make.
U
3

This illustration assumes that all inventory started during the period was completed during the period. Patillo
therefore uses only one inventory account, Finished Goods Inventory. Many manufacturing companies normally
have three categories of inventory on hand at the end of an accounting period: Raw Materials Inventory, Work in
Process Inventory (inventory of partially completed units), and Finished Goods Inventory. Chapter 11 discusses
these inventories in greater detail.

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9

EXHIBIT 1.5
Effect of Product versus Selling and Administrative Costs on Financial Statements
Assets
Event
No.

Cash

1

15,000

2

(2,000)

3

(1,200)

4

(3,000)

Equity
Manuf.
Equip.*

5

Com.
Stk.

5

Ret.
Earn.

15,000

2

Exp.

5

Net Inc.

B
R
5
(2,800) 1
2,800
O 5
6
(600)
(600)
O
7
(4,500) 1
4,500
8
1,000
1
(1,000)
K
9
7,500
7,500
7,500
S 5
10
(4,000)
5
(4,000)
Totals
9,000
1
2,000
1 2,200
1
3,500
5 15,000 1
1,700
7,500
L
*Negative amounts in these columns represent accumulated depreciation.
E
N
The effects of these transactions on the balance sheet and income statement are
shown in Exhibit 1.5. Study each row in this exhibit, T
paying particular attention to
how similar costs such as salaries for selling and administrative personnel and wages
Z
for production workers have radically different effects on the financial statements.
The example illustrates the three elements of product costs, materials (Event 2), labor
,

2

1,200

5

(1,200)

2

600

5

(600)

5

7,500

1

Inventory

Office
Furn.*

Rev.

1

1

1

2,000
5

1

1

(1,200)

3,000

(Event 4), and overhead (Event 8). These events are discussed in more detail below.
Materials Costs (Event 2)
B
Materials used to make products are usually called raw materials. The cost of raw maR
terials is first recorded in an asset account (Inventory). The cost is then transferred
from the Inventory account to the Cost of Goods SoldI account at the time the goods
are sold. Remember that materials cost is only one component of total manufacturing
D
costs. When inventory is sold, the combined cost of materials, labor, and overhead
G
is expensed as cost of goods sold. The costs of materials that can be easily and
conveniently traced to products are called direct raw materials costs.
I
Labor Costs (Event 4)
T
The salaries paid to selling and administrative employees (Event 3) and the wages paid
to production workers (Event 4) are accounted for differently. Salaries paid to selling
2
and administrative employees are expensed immediately, but the cost of production
wages is added to inventory. Production wages are expensed as part of cost of goods sold
0
at the time the inventory is sold. Labor costs that can be easily and conveniently traced
4
to products are called direct labor costs. The cost flow of wages for production employees
versus salaries for selling and administrative personnel is4
shown in Exhibit 1.6.

B
Overhead Costs (Event 8)
Although depreciation cost totaled $1,600 ($600 on office furniture and $1,000 on manU
ufacturing equipment), only the $600 of depreciation on the office furniture is expensed
directly on the income statement. The depreciation on the manufacturing equipment is
split between the income statement (cost of goods sold) and the balance sheet (inventory). The depreciation cost flow for the manufacturing equipment versus the office
furniture is shown in Exhibit 1.7.

2

4,000

5

(4,000)

2

5,800

5

1,700

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Chapter 1

EXHIBIT 1.6
Flow of Labor Costs
Labor costs

Balance sheet
Inventory

Production
wages

Selling and
administrative
salaries

EXHIBIT 1.7
Flow of Depreciation Costs
Overhead cost
Depreciation on
manufacturing
equipment

Depreciation on
office furniture

Total Product Cost.
shown in Exhibit 1.8.

B
R
O
O
K
S
L
E
N
T
Z
,

Income statement
Cost of goods sold

Salaries expense

Balance sheet
Inventory

B
R
I
D
G
I
A summary of
T

Income statement
Cost of goods sold

Depreciation
expense

Patillo Manufacturing’s total product cost is

Financial Statements
2
The income statement and balance sheet for Patillo Manufacturing are displayed in
0
Exhibit 1.9.

4

Product Costs. The $4,000 cost of goods sold reported on the income statement in4
cludes a portion of the materials, labor, and overhead costs incurred by Patillo during
the year. Similarly, the $2,000 of finished goods inventory on the balance sheet includes
B
materials, labor, and overhead costs. These product costs will be recognized as expense
U
in the next accounting period when the goods are sold. Initially classifying a cost as a
product cost delays, but does not eliminate, its recognition as an expense. All product
costs are ultimately recognized as expense (cost of goods sold).
Selling, General, and Administrative Costs. Selling, general, and administrative costs
(SG&A) are normally expensed in the period in which they are incurred. Because of this
recognition pattern, nonproduct expenses are sometimes called period costs. In Patillo’s

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Management Accounting and Corporate Governance

EXHIBIT 1.9

EXHIBIT 1.8

PATILLO MANUFACTURING COMPANY

Schedule of Inventory Costs
Materials
Labor
Manufacturing overhead*
Total product costs
Less: Cost of goods sold
Ending inventory balance

11

$2,000
3,000
1,000
6,000
(4,000)
$2,000

*Depreciation [($4,500 2 $1,500) 4 3]

case, the salaries expense for selling and administrative employees and the depreciation
on office furniture are period costs reported
directly on the income statement.

Overhead Costs: A Closer Look

Financial Statements
Income Statement for 2013
Sales revenue
Cost of goods sold
Gross margin
SG&A expenses
Salaries expense
Depreciation expense—office furniture
B
Net income

R
O Balance Sheet as of December 31, 2013
Cash O
Finished goods inventory
K
Office furniture
$2,800
Accumulated depreciation
(600)
S
Book value
Manufacturing equipment
4,500
Accumulated depreciation
(1,000)
L
Book value
E
Total assets
N
Stockholders’ equity
Common stock
T
Retained earnings
Z
Total stockholders’ equity
,

Costs such as depreciation on manufacturing
equipment cannot be easily traced to products. Suppose that Patillo Manufacturing
makes both tables and chairs. What part of
the depreciation is caused by manufacturing
tables versus manufacturing chairs? Similarly, suppose a production supervisor oversees employees who work on both tables and
chairs. How much of the supervisor’s salary
relates to tables and how much to chairs?
Likewise, the cost of glue used in the production department would be difficult to trace to tables versus chairs. You could count the
drops of glue used on each product, but the informationB
would not be useful enough to
merit the time and money spent collecting the data.
R
Costs that cannot be traced to products and services in a cost-effective manner are
I
called indirect costs. The indirect costs incurred to make products are called manufacturing overhead. Some of the items commonly included D manufacturing overhead are
in
indirect materials, indirect labor, factory utilities, rent of manufacturing facilities, and
G
depreciation on manufacturing assets.

I
T
CHECK YOURSELF 1.2

2

Lawson Manufacturing Company paid production workers wages of $100,000. It incurred
materials costs of $120,000 and manufa…

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