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 AccountingFor 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 AccountingThe 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 Accounting2. Cost Accounting3. Internal Auditing4. Tax Accounting5. Management Accounting6. Financial Forecasting or Budgeting7, 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 vice-president of finance, who in turn is accountable directly to the president.

Finance and personnel are service functions. The line functions are production and sales.

Figure 1.1 Organization Chart

Vice-Pres.For

Production

President

Vice-Pres.For

Sales

Vice-Pres.For

Finance

Vice-Pres.For

Personnel

Controller Treasurer

GeneralAccounting

CostAccounting

ManagementAccounting

System Designand EDP

Budgeting TaxPlanning

InternalAuditing

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, ServicesThe 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

QUESTIONS1. What is the basic function of accounting?2. Distinguish between financial accounting and managerial accounting3. Give similarities between financial accounting and managerial accounting4. 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 2STATEMENT 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, and2. 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 items2. Amount of funds provided by normal operations3. Other specific sources of funds like borrowing4. Funds used for specific purposes such as payment of dividends and acquisition of

noncurrent assets5. 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 equivalents2) Cash and temporary securities3) 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 InformationThese funds statement can be prepared from the following information:1) The balance sheets of the current year and the immediately preceding year2) Income statement data3) 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 StatementThere 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 ProblemTo illustrate the preparation of a funds statement, assume the following data for the San Pedro

Company:Balance Sheet

December 31Assets 19A 19BCash P 12,200 P 19,750Accounts receivable P 32,400 P 34,000

Less allowance forBad debts 2,600 29,800 2,800 31,200

Merchandise Inventory 34,000 40,600Prepaid expenses 1,600 1,400Investments 16,000 6,000Office equipment P 10,500 P 9,500

Less accumulatedDepreciation 1,500 9,000 1,050 8,450

Buildings P 150,000 P 150,000Less accumulated

Depreciation 30,000 120,000 35,000 115,000Land 100,000 130,000 Total assets P 322,600 P 352,400

Liabilities & Stockholders’ Equity

Accounts Payable P 24,500 P 25,000Notes Payable 5,000 4,000Accrued expenses 3,000 2,550Bonds payable -10% P 50,000 P 50,000

Less discount on bonds 2,250 47,750 2,000 48,000Preferred stock 50,000 50,000Common stock, P10 par 100,000 150,000Premium on common stock 5,000 10,000Retained Earnings 87,350 62,850Total Liabilities and

stockholders’ equity P 322,600 P 352,400

Income StatementFor the Year Ended December 31,19b

Sales P 168,000Less cost of goods sold 98,000Gross Profit P 68,000 Less operating expenses (including depreciation of P 5,150) 54,550Net operating income (carried forward) P 13,650

Net operating income (brought forward) P 13,650Other revenues (gains) and expenses (losses):

Interest expense P 5,250Loss on sale of equipment 900

P 6,150Gain on sale of investments 2,500 3,650

Net Income before taxes P 10,000Less Income Tax 3,500Net Income 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 ConceptWhen 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 CapitalThe 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 Working CapitalCurrent assets: 19A 19B Increase Decrease

Cash P 12,200 P 19,750 P 7,750Accounts receivable 32,400 34,000 1,600Allowance for bad Debts ( 2,600) ( 2,800) P 200Merchandise inventory 34,000 40,000 6,600Prepaid expense 1,600 1,400 200

Total current Assets P 77,600 P 92,950_

Current liabilities:Accounts payable P 24,500 P 25,000 500Notes payable 5,000 4,000 1,000Accrued expenses 3,000 2,550 450

Total current Liabilities 32,500 31,550

Working capital P 45,100 P 61,400Increase in working capital ___ 16,300_

P 17,200 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 AccountsAfter 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 operations2) Issuance of capital stock3) Issuance of long-term debt4) 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 owner’s equity.

1) Loss from operations2) Retirement or acquisition of treasury stock3) Retirement of long-term debt4) Acquisition of noncurrent assets, investments, and other noncurrent assets5) 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 EarningsRetained earnings decreased by P 24,500. The decrease in Retained Earnings is accounted for as

follows:Net Income, per income statement P 6,500Deduct: 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) InvestmentsThere 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 equipmentThe 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 9,500Add: Cost of equipment sold 5,000_

P 14,000Deduct: 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 EquipmentThe 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 1,050Add: Decrease in accumulated depreciation 600 due to sale of equipment P 1,650Deduct: 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) BuildingsThere was no change in the buildings account during the year.(f) Accumulated depreciation-buildingsThe 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) LandThe 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 PayableThis account remained unchanged during the year.(i) Discount on Bonds PayableThe 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 StockNo change in this account occurred during the year.(k) Common StockThe 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 StockThe 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 CompanyStatement of Changes in Financial Position

For the Year ended December 31, 19B

Working capital was provided by:Operations: Net Income P 6,500 Add: items not requiring working capital:

Loss on sale of equipment P 900 Depreciation 5,150

Bond discount amortization 250 6,300_P 12,800

Deduct: items not providing working capital: Gain on ale of investments 2,500_Working capital provided by operations P 10,300Sale of investments 12,500Sale of office equipment 3,500Issuance of common stock to purchase land 30,000_

Total working capital provided P 56,300

Total working capital was applied to:Payment of cash dividends P 6,000Purchase of office equipment 4,000Purchase of land through issuance of

Common stock 30,000_Total working capital applied 40,000_

Increase in working capital 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 ApproachThe 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 CompanyWork Sheet for Statement of Changes in Financial Position

(Working Capital Basis)For the year ended December 31, 19B

Items Balance BalanceDec. 31 Adjustments Dec. 31

Debits 19A Debit Credit 19BWorking capital 45,100 (1) 16,300 61,400Investments 16,000 (d) 10,000 6,000Office equipment 10,500 (e) 4,000 (f) 5,000 9,500Buildings 150,000 150,000Land 100,000 (i) 30,000 130,000 Discount on Bonds 2,500 (k) 250 2,000

Total 323,850 358,900

CreditsAccumulated depr- 1,500 (f) 600 (g) 150 1,050 equipmentAccumulated depr. 30,000 (h) 5,000 35,000 buildingsBonds payable 50,000 50,000Preferred stock 50,000 50,000Common stock 100,000 (c) 25,000 150,000

(j) 25,000Premium on common stock 5,000 (j) 5,000 10,000Retained earnings 87,350 (b) 6,000 (a) 6,500 62,850

(c) 25,000 Total 328,850 358,900

Working Capital was provided by:Operations:Net income (a) 6,500Gain on sale of investment (d) 2,500Loss on Sale of equipment (f) 900Depreciation-office equipt. (g) 150Depreciation-Buildings (h) 5,500 Bond Discount amortization (k) 250Sale of investments (d) 12,500 Sale of office equipment (f) 3,500Issuance of stock for land (j) 30,000

Working capital was applied to:Payment of cash dividends (b) 6,400Purchase of equipment (e) 4,000Purchase of land (i) 30,000

Increase in working capital (l) 16,300Total 140,700 140,700

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 6,500Retained earnings P 6,500

To record funds provided by incomefrom operations.

(b) Retained Earnings P 6,000Funds applied to cash dividends P 6,000

To record funds applied to paymentof 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 10,000Net income-gain on sale of investments 2,500

To record funds provided by saleof investments.

(e) Office Equipment P 4,000Funds applied to purchase of equipment P 4,000

To record funds applied to purchaseof 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 5,000To record funds provided by sale of

Office equipment.(g) Net income-depreciation P 150

Accumulated depreciation- Off. Equip. P 150

To record funds provided by sale ofoffice equipment.

(h) Net income-Depreciation P 5,000Accumulated 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 purchaseof land.

(j) Funds provided by issuance P 30,000

of stockCommon stock P 25,000Premium on common stock 5,000

To record funds provided by issuanceof stock to purchase land.

(k) Net income-Bond discount P 250Discount on bonds payable P 250

To record amortization of bond discount.(l) Working Capital P 16,300

Increase in working capital P 16,300To record increase in working capital.

Working Capital Provided by OperationsThe 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 xxxAdd charges not requiring outlay of working capital xxx_

P xxxDeduct 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 expense2) Loss on sale of assets3) Amortization of intangibles4) Amortization of bond investment premiums5) Amortization of bond payable discounts6) Increase in deferred income taxes7) Share in the loss of a subsidiaryThe 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 assets2) Amortization of bond investment discounts3) Amortization of bond payable premiums4) 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 operationsif 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 itemsExtraordinary 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 Operations-Alternative 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 P 168,000Deduct: Cost of goods sold P 99,800

Operating expenses (excluding depreciation of P 5,150) 49,000 Interest expense ( P 5,250 less discount of P 250) 5,000 Income taxes 3,500 P 157,000_

Working capital provided by operations 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 capital2) Changes in noncurrent accounts which do not affect working capital.Changes in noncurrent accounts which affect working capital may be summarized as follows:

Change Effect

Increases in noncurrent assets (Debits) Decrease working capitalDecreases in noncurrent assets (Credits) Increase working capitalIncreases in noncurrent equities (Credits) Increase working capitalDecreases in noncurrent equities (Debits) 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 vice-versa. This increases or decreases working capital since current assets are either increased or decreased.

Nonworking Capital Not Affecting Working CapitalChanges 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 assetb) Issuance of stock dividends and stock splitsc) Appraisal of assetsd) Appropriation of retained earningse) 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 debtb) Acquisition of assets in exchange for other assetsc) Conversion of preferred stock or long-term debt in common stockd) Settlement of debt or liquidation of ownership interests through the transfer of long-term assetse) Properties received as gifts or donations

Cash Concept of FundsWhen 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, and2) 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 CompanyStatement of Changes in Financial Position

For the Year Ended December 31, 19B

Cash was provided by:Operations:Net Income P 6,500

Items to be added to net income:Depreciation P 5,150Loss on sale of equipment 900Bond discount amortization 250Decrease in repaid expenses 200Increase in accounts payable 500 7,000

P 13,500Items to be subtracted from net income:

Gain on sale of investments P 2,500Increase in accounts receivable (net) 1,400Increase in merchandise inventory 6,600Decrease in notes payable 1,000Decrease in accrued expenses 450 11,950

Cash provided by operations P 1,550 Sale of investments 12,500Sale of office equipment 3,500Issuance of common stock to purchase land 30,000

Total Cash provided P 47,550Cash was applied to:

Purchase of office equipment P 4,000Payment of cash dividends 6,000Purchase of land through issuance of stock 30,000

Total cash applied 40,000Increase in Cash P 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 MethodThe 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 SalesMerchandise inventory- related to Cost of Goods SoldAccounts payable- related to PurchasesPrepaid expenses- related to Operating ExpensesAccrued expenses- related to operating ExpensesIncome tax payable- related to Income Taxes ExpenseSome 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 P 168,000Add: Accounts receivable, beginning 32,400

P 200,000Deduct: Accounts receivable, end P 34,000

Write-off of accounts receivable 600 34,600Collections on sales P 165,000

(2) Computation of Payments for merchandise:Cost of goods sold P 99,800Add: Merchandise 40,600Goods available for sale P 140,000 Deduct: Merchandise inventory, beginning 34,000Cost of purchases P 106,400Add: Accounts payable, beginning P 24,500 Notes payable-trade, beginning 5,000 29,500

P 135,900Deduct: Accounts payable, end P 25,000

Notes payable-trade, end 4,000 29,000Cash payment for merchandise P 106,000

(3) Computation of payments for operating expenses:Operating expenses P 54,000Add: Prepaid expenses, end P 1,400 Accrued expenses, beginning 3,000 4,000

P 58,950Deduct: Prepaid expenses, beginning P 1,600

Accrued expenses, end 2,550 Depreciation 5,150 Bad debts 800 10,100

Payments for operating expenses P 48,850

(4) Computation of payment for interest:Interest expense P 5,250Less bond discount amortization 250Cash paid for interest P 5,000

(5) Payment for income tax expenseSince 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 165,000Payments-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 andDeduct from related expenses

Increase in current liabilities Add to related revenues and deductfrom related expenses

Decrease in current liabilities Deduct from related revenues andadd 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 P 54,550

Add decrease in accrued expenses 450 P 55,000

Deduct: Decrease in prepaid expenses P 400 Depreciation 5,150 Bad debts 800 6,150

Payment for operating expenses P 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 period2) Enter the net change in a working capital account3) Determine the net change in each noncurrent or nonworking capital account and post the net

changes to the T-accounts4) Enter all transactions in the T-accounts. Transactions affecting working capital are entered in

the Working Capital account5) 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 CapitalNet Change

(Increase) (Decrease)

Sources-Operational: Applications-Operations:

Sources-Others: Applications-Others:

Net change in nonworking capital accounts is determined from the following equation:Beginning balance – Increases = Ending Balance – DecreasesEnding Balance – Beginning Balance = Increases – DecreasesNet 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 AccountsNet Change (increase)

Increases Decreases

Liability accountsNet change (Increase)

Decreases Increases

Owners’ Equity accountNet 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 – DecreasesTo 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 6,500Retained earnings P 6,500

working capital provided by income from operations.

(2) Retained earnings 6,600Working capital-others 6,000

working capital applied to cash dividends.

(3) Retained earnings 25,000Common stock 25,000

Stock dividends.(4) Working capital-others 12,500

Investments 10,000Working capital-operations 2,500

Sale of investments at a gain.(5) Office equipment 4,000

Working capital-others 4,000Purchase of equipment.

(6) Working capital-others 3,500 Accumulated depreciation-office equipment 600 Working capital-operations 900

office equipment 5,000Sale of office equipment at a loss.

(7) Working capital-others 150Accumulated depreciation-office equipment 150

Depreciation on building.(8) Working capital-Operations 5,000

Accumulated depreciation-buildings 5,000Depreciation on building.

(9) Land 30,000Working capital-Others 30,000

Purchase of land

(10) Working capital-Others P 30,000Common stock P 25,000Premium on common on stock

Issuance of stock for land.(11) Working capital-Operations 250

Discount on bonds payable 250Amortization of bond discount.

Working CapitalNet change P 16,300

Sources-Operations: Applications-Operations:

1. Net income 6,500 4. Gain on sale of 6. Loss on sale of investment 2,500

equipment 900 7. Depn.-equipt, 150 8. Depn-bldg. 5,000 11. Discount amort. 250 Sources-Others: Applications-Others: 4. Sale of invest- 2. Payment of cash dividends 6,000

ments 12,500 5. Purchase of equipment 4,000 6. Sale of equipt. 3,500 9. Purchase of land 30,000 10. Issuance of stock 30,000

Investments Net change P10,000

4. Sale of investments 10,000

Office Equipment Net change P 1,000

5. Purchae of equipment 4,000 6. Sale of equipment 5,000

Accumulated depreciation-office equipmentNet change P 450

6. Sale of equipt. 600 7. Depreciation 150

Accumulated depreciation-building Net change P 5,000

8. Depreciation 5,000

LandNet change P 30,000 9. Purchase of land 30,000

Discount on Bonds Net change P 250

11. Discount amortization 250

Common Stock Net change P 50,000 3. Stock dividends 25,000 10. Issuance of stock 25,000

Premium on Common Stock Net change P 5,000

10. Issuance of stock 5,000

Retained Earnings Net change P 24,500

2. Cash dividends 6,000 1. Net income 6,5003. Stock dividends 25,000

QUESTIONS1. 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 P 40,000Sale of marketable securities 28,000Net income 75,000Depreciation 10,000Loss o n sale of equipment 4,000Proceeds from sale of equipment 35,000Issuance of common stock in exchange

for equipment 50,000Purchase of equipment 50,000Declaration of cash dividends 30,000Interest received in advance 8,000Loss from inventory decline to market 3,000Increase in inventory 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 P 60,000Discount on bonds payable 6,000Increase in inventories 38,000Decrease in prepaid expenses 10,000Issuance of long – term note to purchase equipment 45,000Purchase of equipment 45,000Decrease in accounts receivable 30,000Purchase of treasury stock 32,000Increase in accounts payable 26,000Decrease in accrued expenses 18,000Depreciation 21,000Amortization of patents 16,000Gain on sale of equipment 7,000Proceeds from sale of equipment 42,000Net income 60,000Declaration of stock dividend 24,000Investment in bonds 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 31Year 2 Year 3

Long-term investments P 2,000,000 P 2,500,000Equipment, net 3,400,000 4,000,000Capital stock 5,000,000 6,500,000Retained 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 4,000Marketable securities 20,000Allowance for bad debts 2,000Unearned rental income 9,000Notes payable (long-term) 30,000Prepaid insurance 5,000Investment in subsidiary company 40,000Land held for future use 60,000Accounts payable 15,000Inventory 28,000Cash 7,000Accounts receivable 12,000

Interest payable 6,000Deferred income tax (noncurrent) 8,000Bonds payable 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 accountd) 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 equipmento) 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 P 40,000Increase in dividends payable 13,000Decrease in stock subscriptions receivable 4,000Income tax refund (due to prior period adjustments) 15,000Decrease in taxes payable 5,000Depreciation 9,000Amortization of goodwill 8,000Uncollectible accounts expense 2,000Increase in bank loans payable 10,000Increase in accounts receivable (net) 20,000Receipt of cash dividends 14,000Decrease in unearned interest income 6,000Decrease in prepaid expense 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 P 76,000Write-off of patent 19,000Loss on sale of equipment 11,000Decrease in deferred income tax 18,000Depreciation 6,000Decrease in bank loans payable 22,000Decrease in marketable securities 20,000Gain on sale of marketable securities 12,000Loss from earthquake damage plant 30,000Decrease in inventories (net) 19,000Loss o n inventory decline to market 8,000Increase in interest receivable 14,000Decrease in prepaid expenses 10,000Share in net income of subsidiary 16,000

9. From the following information, determine the cash provided by operations:

Net income P 21,000Extraordinary loss from earthquake 35,000 damage, net of tax of P 15,000Income tax applicable to extraordinary income 24,000Depreciation 40,000Repairs and maintenance 40,000Increase in accounts receivable 50,000Decrease in inventories 20,000Increase in accounts payable 35,000Increase in income taxes payable (applicable to ordinary income) 15,000Cash applied to construction of building 100,000

10. The income statement of a merchandising business is presented below.

Net salesLess Cost of goods soldGross profitOperating expenses: Salaries Rent Supplies Bad debts expense MiscellaneousNet 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 P 1,500,000Cost of goods sold:

Direct materials P 450,000Direct labor 300,000Factory 150,000 900,000

Gross profit P 600,000Operating expenses 450,000Operating income P 150,000Interest income 20,000Net income before P 170,000Income taxes 40,000Net income P 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 0b. P 4,800c. P 25,000d. 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 10a. P 0 P 0b. P 10,000 P 0c. P (10,000) P 0d. 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 2,000,000Provision for doubtful accounts on short – term receivables 200,000Provision for doubtful accounts on long – term receivables 300,000Dividends 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 4,900,000b. P 6.000,000c. P 6,300,000d. P 6,500,000

AICPA 15. Selected information from Bejar Corporation’s accounting records and financial statements for 19A is as follows:

Working capital provided by operations P 1,500,000Mortgage payable issued t acquire land

and building P 1,800,000Common stock issued to retire preferred stock 500,000Proceeds from sale of equipment 400,000Cost of office equipment purchased 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 1,700,000b. P 2,400,000c. P 3,700,000d. P 4,200,000

AICPA

16. Ace Company’s 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 850,000Capital expenditures 1,500,000Short – term borrowings 500,000Long – term borrowings 1,000,000Payments on short – term borrowings 250,000Payments on long – term borrowings 300,000Proceeds from issuance of common stock 700,000Dividends paid on common stock 400,000

How much was Ace’s working capital at December 31, 19B?a. P 5,350,000b. P 5,600,000c. P 5,750,000d. 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 12/31/19BMachinery P 250,000 P 320,000Accumulated depreciation – machinery 102,000 120,000Loss 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 32,0002. 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 Company’s accounting records for the year ended December 31, 19B:

Cash received from customers P 870,000Rent received 10,000Cash paid to suppliers and employees 510,000 Taxes paid 110,000Cash dividends paid 30,000

Net cash flow provided by operations for 19B wasa. P 220,000b. P 230,000c. P 250,000d. P 260,000

AICPA

PROBLEMS

2.1 Given below are the balance sheets and selected additional information for the Santiago Company.

December 31 Assets 19C 19D

Cash P 27,000 P 49,150Accounts receivable 80,000 110,000Inventory 132,000 180,000Land, buildings, and equipment 290,000 459,000Allowance for depreciation ( 120,000) ( 135,000)Patents 40,000 _ Total assets P 449,000 P 663,150

EquitiesAccounts payable P 24,000 P 19,000Notes payable 50,000Accrued expenses 15,000 16,000Bonds payable 100,000Discount on bonds payable ( 5,850)Capital stock 200,000 250,000Additional paid – in capital 30,000 36,000Retained earnings 180,000 198,000 _ Total equities P 449,000 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 19E 19F

CashMarketable securitiesAccounts receivable (net)Merchandise inventoryLong – term investmentsPlant and equipmentDiscount on bonds payable Total

CreditsAccumulated depreciationAccounts payableDividends payableBonds payableCapital 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.

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 P 80,000 P 130,000Deferred income tax 46,000 61,000Capital stock (P 100 par) 205,000 305,000Paid-in-capital 115,000 165,000Retained earnings 105,000 140,000

Noncurrent assets:Investments P 125,000 P 150,000Plant and Equipment (net) 345,000 550,000Intangibles assets 75,000 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 yearDebit Credit

Current assets P 55,000Investments 21,000 Plant and equipment 153,000Intangibles P 8,000Current liabilities 46,000Long – term assets 30,000 Capital stock 15,000Donated capital 100,000 Retained earnings 90,000

P 259,000 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 P 20,000 Retained earnings P 14,000 Income tax payable 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 Year 4 Year 5

Cash P 34,025 P 95,810Accounts receivable 13,000 41,375Inventory 32,000 57,180Land 140,000 130,000Building – net 432,000 414,000Equipment – net 112,000 100,000Patents 58,000_ 80,625_

P 821,150 P 919,390

Accrued expenses P 6,250 P 7,300Accounts payable 17,500 15,000Bonds payable 80,000 60,000Premium on bonds payable 2,400 1,620Common stock (P 25 par) 312,500 400,500Paid – in capital 177,500 196,270Retained earnings 248,000 247,900Treasury stock, at cost ( 23,000)_ ( 9,200)

P 821,150 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 26,000Amortization of bond premium 210Amortization 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 Assets 19A 19BCurrent assetsInvestmentsLandBuildingsAccumulated depreciation – buildingEquipmentAccumulated depreciation – equipmentGoodwill

Total assets

EquitiesCurrent liabilitiesBonds payableDiscount on bonds payablePreferred stock (P 25 par)Common stock (P 50 par)Capital in excess of par – commonRetained earningsAppraisal capitalTreasury 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 December 31 19A 19B

CashAccounts receivableMerchandise inventorySuppliesFurniture and fixtures – net

Total assets

Liabilities and capitalAccounts payableAccrued expensesNotes payable – bankSarmiento, 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 December 31 19A 19B

CashMarketable securitiesAccounts receivable (net)InventoriesInvestmentsPlant and equipment (net)PatentsDiscount on bonds payable

Total assets

EquitiesAccounts payableIncome taxes payableBonds payablePreferred stock (P100 par)Common Stock (P 50 par)Additional paid – in capitalRetained earnings

Total equities

The income statement of the company for 19B shows the following:

Income before income tax and extraordinary itemIncome tax expenseIncome before extraordinary itemExtraordinary 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 company’s annual report to stockholders.

Assets December 31 19A 19B

CashMarketable securitiesAllowance for decline in value of

marketable securitiesAccounts receivable – netInventoriesInvestment in Tuason, Inc.LandBuildings – netEquipment – netTotal assets

LiabilitiesNotes payable – tradeIncome taxes payableDividends payableBonds payablePremium on bonds payableDeferred income taxes

Total liabilities

Stockholders’ EquitiesCommon stock (P 100 par)Paid – in capitalRetained earnings, appropriated

for treasury stockRetained earningsTreasury stock, at cost

Total stockholders’ equity

Total liabilities and stockholders’equity

Income statement data for the year ended December 31, 19B showed the following summary of operations:

Income before income taxesIncome taxes:

CurrentDeferred

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 SheetsDecember 31

19A 19BAssets:

Current assets:CashAccounts receivable – netMerchandise inventoryPrepaid expenses

Total current assetsLong – term investmentsProperty, plant, and equipmentAccumulated depreciationTotal assets

Equities:

Current liabilities:Accounts payableInterest payableAccrued expensesIncome taxes payableDividends payable

Total current liabilities

Long – term notes payableTotal liabilities

Stockholders’ Equity:Common stockAdditional paid – in capitalRetained earnings

Total stockholders’ equityTotal equities

Income Statements

Year Ended December 31,19A 19B

SalesCost of goods sold

(including depreciation)Gross profitOperating expensesOperating incomeInterest expenseNet income before income taxesIncome taxesNet 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 SheetsDecember 31

Assets 19A 19BCashMarketable securitiesAccounts receivableAllowance for doubtful accountsInventoriesPrepaid expensesInvestment in Acosta Co.LandBuildings (net)Equipment (net)Total assets

EquitiesAccounts payableBank loans payableCurrent maturity of long – term debtDividends payable Income taxes payableBonds payableCapital stock (P 10 par)Paid – in capitalRetained earningsTotal equities

Income and Retained Earnings StatementYear Ended December 31, 19B

Revenues and gains:Net salesGain on sale of marketable securitiesEquity in net income of Acosta Co.

Expenses and losses:Cost of goods soldSelling and administrative expensesIncome taxesInterest expenseLoss 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 – buildingDepreciation – equipmentDoubtful accounts expenseExpired 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)

AssetsCurrent Assets:

CashAccounts receivable, netInventories

Total current assetsLandPlant and equipmentAccumulated depreciationLeased equipment under

capital leaseMarketable investment

securities, at costInvestment in Marzan, Inc.,

at cost Total assets

Liabilities and Stockholders’Equity

Current liabilities:Current portion of long –

term debtAccounts payable and

accrued expensesTotal current liabilities

Notes payable, long – termLiability under capital leaseBonds payableUnamortized bond premiumDeferred income taxesCommon stock, par value P 20Additional paid – in capitalRetained 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) Robinson’s 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

Assets 19B 19C (Decrease) CashMarketable equity securities,

at cost

Allowance to reduce marketableequity securities to market

Accounts receivable, netInventoriesLand Plant and equipmentAccumulated depreciationGoodwill, net

Total assets

Liabilities and Stockholders’Equity

Current portion of long – term debt

Accounts payable and accrued liabilities

Note payable, long – termDeferred income taxesMinority interest in net assets

of subsidiaryCommon stock, par P 10Additional paid – in capitalRetained earningsTreasury stock, at cost

Total liabilities andstockholders’ 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 incomeDoria 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 AssociatesCONDENSED STATEMENTS OF FINANCIAL POSITION

December 31, 19B and 19A

Net Change Increase

Assets 19B 19A (Decrease)

CashAccounts receivable, netInvestment in Kato, Inc., at

equityProperty and equipmentAccumulated depreciationExcess cost over book value of

investment in Kato (net) Total Assets

Liabilities and Partners’Equity

Accounts payable andAccrued expense

Mortgage payablePartnerships’ equity

Total liabilities andpartners’ equity

Public Relations AssociatesCONDENSD STATEMENT OF INCOME

For the Year Ended December 31, 19B

Fee revenueOperating expensesOperating incomeEquity in earnings of Kato, Inc.

(net of P 2,000 amortization of excesscost over book value)

Net income

Additional information:(1) On December 31, 19A, partners capital and profit sharing percentages were as follows:

Capital Profit Sharing %BorjaCalma

(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:

BorjaCalmaDario

(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. Public’s 19B amortization of excess cost over book value in Kato was P 2,000.(5) Partners’ drawings for 19B were as follows:

BorjaCalmaDario

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 analysiswhich 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 amounts2) Percentages3) Ratios4) 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) Increase (Decrease) 19A 19B 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 19B 19C 19D 19ESalesSales 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.

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 CompanyComparative 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 CompanyComparative Balance Sheet

December 31

Common – size StatementsFinancial 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 CompanyCommon – size Income Statements

For the Years Ended December 31, 19A and 19B19B 19A

Net salesCost of goods soldGross profitOperating expenses:

Selling expensesGeneral expenses Total expenses

Operating incomeInterest expenseNet income

Other Bases of ComparisonThe 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. ABC Co.Net Sales Cost of goods soldGross profitOperating expensesNet income

Ratio AnalysisA 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.

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 19C 19B 19ACurrent Assets Cash P 24,000 P 14,000 P 12,000 Marketable securities 30,000 26,000 20,000 Accounts receivable 20,000 35,000 25,000 Inventories:

Raw materials 40,000Work in process 50,000Finished goods 60,000

Prepaid expenses 14,000Total current assets P 238,000

Long-tern investments 100,000Plant assets: Land P 250,000 Building 450,000 Equipment 280,000

Total 980,000Accumulated depreciation 230,000Net 750,000

Total assets P 1,088,000

LiabilitiesCurrent liabilities Accounts payable Notes payable Accrued expenses

Total current liabilitiesLong-tern debt-bondsTotal liabilities

Stockholders’ Equity7% Preferred Stock (P100 par)Common stock (P10 par)Retained earningsTotal stockholders’ equityTotal liabilities and stockholders’ equity

Soliman CompanyComparative Income Statement

For the Years Ended December 3119C 19B 19C

Net salesCost of goods sold:

Direct materials: Materials inventory, Jan. 1 Purchases Materials available for use Materials inventory, Dec. 31 Direct materials usedDirect laborFactory overheadTotal manufacturing costsWork in process inventory, Jan. 1

Work in process inventory, Dec. 31Cost of goods manufacturedFinished goods inventory, Jan. 1Total goods available for saleFinished goods inventory, Dec. 31Cots of goods sold

Gross profitOperating expenses:

Selling expenseAdministrative expense Total operating expense

Net operating incomeNon – operating items:

Interest expenseInterest income Net financial expense

Net income before taxesIncome taxesNet income

Soliman CompanyComparative Retained Earnings Statement

For the Years Ended December 31

Retained Earnings, Jan. 1Net income during the year, per income statementTotalDividends:

PreferredCommonTotal

Retained Earnings, Dec. 31

Ratios Measuring LiquidityLiquidity, 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 ratioThe current ratio, sometimes called the working capital ratio or bankers’ ratio, is the rough

measure of the company’s 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 assetsCurrent ratio = Current liabilities

` The current ratios for the Soliman Co. are computed below.19B 19C

Current assetsCurrent liabilitiesCurrent 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

be made regarding a company’s liquidity.In addition to the current ratio, the following factor affecting liquidity should be considered:1) The nature of the company’s 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 company’s 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 assetsThe proportion of each current asset to the total current assets of the Soliman Company is shown

on the following page

Quick ratioThe 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 assetsQuick ratio = Current liabilities

Percentage Distribution of Current Assets19B 19C

Current assets: Amount % Amount &CashMarketable securitiesAccounts receivableRaw materials inventoryWork in process inventoryFinished goods inventoryPrepaid expenses

Total current assets

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:CashMarketable securitiesAccounts receivableTotal quick assets

Total current liabilitiesQuick ratio

Accounts Receivable TurnoverThe 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 salesAccounts receivable turnover = Average accounts receivable

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 19C Net salesAverage accounts receivableAccounts receivable turnover

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 receivablesThe 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 receivablesNumber 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 19CAverage accounts receivableNet salesDays 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 19C = 360 days30 43.64

= 12 days = 8 days

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 19CAccounts receivable, year endNet salesDays in year (assumed)Number of days’ sales in ending receivables

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 turnoversIn 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 turnoverThe 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 = Cost of goods soldturnover Average finished goods inventory

The finished goods inventory turnovers for the Soliman Co. are calculated as follows:

19B 19CCost of goods soldAverage finished goods inventoryFinished 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

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 inventoriesThe 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 = Average finished goods inventory Inventories Cost of goods sold X Days in year

The number of days’ sales in inventories for the Soiman Co. are:

19B 19CAverage finished goods inventoryCost of goods soldDays in yearNumber of days’ sales in inventories

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 19C= 360 days 9.04 8.98

= 40 days = 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 – endCost of goods soldDays in yearNumber of days’ sales in ending inventories

Work in process inventory turnoverThe 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 19CCost of goods manufacturedAverage work in process inventoryWork in process turnoverDays to turnover work in process

Raw materials turnoverThe 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 usedAverage raw materials inventoryRaw materials turnoverDays to turnover raw materials

The Operating CycleThe 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.

DaysDays to convert raw materials to work in processDays to convert work in process to finished goodsNumber of days’ sales in inventoriesNumber of days’ sales in receivablesOperating cycle

Accounts payable turnoverThe 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.

Calculations of the accounts payable turnovers and number of days’ purchases in payables for the Soliman Co. are made below.

19B 19CPurchasesAverage accounts payableAccounts payable turnoverNumber of days’ purchases I payables

Current asset turnoverThe 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 SalesCurrent 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 19CNet salesAverage current assetsCurrent asset turnover

Using the second formula, the calculations for the Soliman Co. are:

19B 19CCost of goods soldOperating expenses

TotalLess depreciationCost of goods sold plus operating

expenses (excluding depreciation)Average current assetsCurrent asset turnover

Number of Days to Cover WorkingCapital 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

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 – endLess current liabilities, year – endWorking 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 X Operating Days in Year

Operations

Ratios Measuring ProfitabilityProfitability 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, and3) 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, and2) 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, and3) 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 salesThe 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 19CNet income after taxesNet salesRate 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 rateThe 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 profitNet salesGross profit rate

Rate of operating profitThe 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 incomeNet salesRate of operating profit

Expense RatiosThe operating ratio and operating expense ratio are given by the following formulas:

Operating ratio = Cost of goods sold – Operating expensesNet 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 19CCost of goods soldOperating expensesCost of goods sold plus operating expensesNet salesOperating ratioOperating expense ratio

Rate of return on total assetsThe 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 = Net income total assets Average total assets

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 19CNet incomeAverage total assetsRate 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 Net Sales total assets Net sales Average total assets

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 Asset turnover Rate of return on sale rate on total assets 4% 5.0 20% 5% 4.0 20% 8% 2.5 20% 10% 2.0 20% 20% 1.0 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 19COperating incomeAverage operating assets (total assets

less investments)Operating rate of return

Rate of return on total stockholders’ equityThis 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.

The rates of return on total stockholders’ equity for the Soliman Co. are developed as follows:

19B 19CNet incomeAverage total stockholders’ equityRate earned on total stockholders’ equity

Rate of return on common stockholders’ equityThe rate earned on the resources provided by the common stockholders, or residual owners, can

also be computed as follows:

Rate of return on common = Net income – preferred dividendsstockholders’ equity Average common stockholders’ equity

For the Soliman Co., the rates are computed as follows:

19B 19CNet income Less preferred dividendsNet income applicable to commonAverage common stockholders’ equityRate earned on common stockholders’ equity

Financial LeverageFinancial 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 stock5% Bonds payable P 400,000 P -Common stock 600,000 1,000,000Total 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.

Issue Bonds Issue Stock

Operating income (10% of P1, 000, 000) P100, 000 P100, 000 Less interest expense (5% of P400, 000) 20, 000 - ____ Net income before income taxes P 80, 000 P100, 000Less income taxes (30%) 24, 000 30, 000_Net income P 56, 000 P 70, 000_

Rate of return on total assets 5.60% 7.00%Rate of return on common stockholder’s

equity 9.33% 7.00%

The rate of return on the common stockholder’s 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%) P40, 000Less income taxes (P40, 000 x 30%) P12, 000

P28, 000Interest on borrowed funds (40, 000 x 5%) P20, 000Less income taxes (P20, 000 x 3%) 6, 000 14, 000Net advantage to stockholders 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, 000Net income before taxes P20, 000 P40, 000Less income taxes 6, 000 12, 000Net income P14, 000 P28, 000Rate 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%) P16, 000Less income taxes (P16, 000 x 30%) 4, 800

P11, 200

Interest on borrowed funds (P400, 000 x 5%) P20, 000Less income taxes 6, 000 14, 000Net disadvantage to stockholders (P 2, 800)Profitability Ratios for Stocks

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 share2. Dividends per share3. Book values per share4. Price-earnings ratio5. Dividend yield6. Dividend payout ratio

Earnings per share

The earnings per share measures the amount of earnings applicable to each share of common

Earnings per share = Net income – Preferred dividendsAverage number of common shares

OutstandingThe 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.

The earnings per share for the Soliman Co. are:19B 19C

Net income P199, 500 P306, 800Less preferred dividends paid _ 7, 000 __ 7, 000Income applicable to common stock P192, 500 P 299, 800Number of common shares outstanding 15, 000 20, 000Earnings per share P 12.83 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 19CTotal dividends paid on common stock P180, 500 P201, 800Number of common shares outstanding 15, 000 20, 000Dividends 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 Stockholders’ equity applicable toof preferred stock = Preferred stock___________

Number of preferred shares outstanding

Book value per share Total stockholders’ equity – Equityof common stock = ___applicable to preferred stock______

Number of common shares outstanding

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 19CTotal stockholders’ equity P498, 000 P646, 000Less equity preferred:

Liquidation value 1, 000 shares at P100 100, 000 100, 000Equity applicable to common P398, 000 P546, 000

Book values per share:Preferred stock P 100. 00 P100. 00Common stock 26.53 27.30

Price-earnings ratioThe 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 19CMarket price per share P80.00 P100.00Earnings per share 12.83 14.99Price-earnings ratio 6.24 6.67

Dividend yieldThe 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 19CDividends per share P12.03 P10.09Market price per share 80.00 100.00Dividend yield 15.04% 10.09%

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 P12.03 P10.09Earnings per share 12.83 14.99Payout ratio .94 .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 StabilityStability, 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 business2. The asset coverage of long-term debt3. The earnings coverage of fixed charges.

Capital Structure analysisThe 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

Equity ratio = Total stockholders’ equityTotal assets

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 P556, 000 P442, 000

Total stockholders’ equity 498, 000 646, 000Total assets 1,054,000 1,088, 000 Debt ratio .53 .41Equity ratio .47 .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

Equity-to-debt ratio = Total stockholders’ equity Total liabilities

The above ratios are computed for the Soliman Co. below.19B 19C

Total liabilities P556, 000 P442, 000Total stockholders’ equity 498, 000 646, 000Debt-to-equity ratio 1.12:1 .68:1Equity-to-debt ratio .90:1 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 debtThe 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 19C

Plant and equipment (net) P715, 000 P750, 000Long-term debt 400, 000 300, 000Ratio of plant and equipment to long-

term debt 1.79:1 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 earned2. Times preferred dividends earned3. Times interest and preferred dividends earned4. Times all fixed charges earned.

Times interest earnedThe 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 taxesTimes 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 19C

Net income before taxes P285, 000 P472, 000Add interest expense 25, 000 20, 000Net income before interest and taxes P310, 000 P492, 000Interest expense 25, 000 20, 000Times interest earned

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 earnedThe 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:19B 19C

Net income P199, 500 P306, 800 Preferred dividends 7, 000 7, 000Times preferred dividends earned 28.50 43.83

Times interest and preferred dividends earned

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 dividendsearned 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 19C

Net income before taxes P285, 000 P472, 000Interest expense 25, 000 20, 000Net income before interest and taxes P310, 000_ P492, 000Preferred dividends:

19B – P7, 000 ÷ (1 - .30) 10, 00019C – P7, 000 ÷ (1 - .35) ______ 10, 769

Total 35, 000 30, 769Times interest and preferred dividends earned 8.86 15.99

Times all fixed charges earnedInterest 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 = Net income before taxes –Fixed chargescharges earned Fixed charges

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.

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 19Ca. Sales P20, 000 P30, 000b. Operating expenses 25, 000 10, 000c. Cash (10, 000) 50, 000d. Allowance for depreciation 30, 000 60, 000e. Retained earnings 60, 000 (90, 000)f. Net loss (20, 000) (30, 000)g. Treasury stock 10, 000 25, 000h. Premium on common stock 40, 000 40, 000i. Accounts payable 25, 000 20, 000j. Working capital (70, 000) (35, 000)

2. Selected data for the Zeny Corporation over a period of five years are presented below.

19A 19B 19C 19D 19Ea. Sales P150, 000 P202, 500 P216, 000 P238, 500 P258, 000b. Net income 40, 000 70, 400 88, 000 81, 600 74, 800

c. Earnings per share 2.00 1.92 2.10 1.88 2.24 d. Total liabilities 400, 000 380, 000 368, 000 372, 000 360, 000e. Total assets 750, 000 757, 000 772, 000 765, 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. XYZ Co.Net sales P400, 000 P600, 000Cost of goods sold 288, 000 408, 000Gross profit P112, 000 P192, 000Operating expenses 72, 000 144, 000Operating income P 40, 000 P 48, 000Income taxes 12, 000 15, 000Net income P 28, 000 P 33, 000

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.December 31

19A 19BAssets

Cash P21, 000 P26, 000Accounts receivable 32, 000 43, 000Inventories 55, 000 62, 000Plant, assets, net 120, 000 138, 000Total assets P228, 000 P269, 000

Liabilities and Stockholders’ Equity

Accounts payable P 44, 000 P 52, 000Accrued expenses 18, 000 21, 000Common stock 150, 000 160, 000Retained earnings 16, 000 36, 000 Total liabilities and stockholders’ equity P228, 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 P16, 000Dividends payable 6, 000Temporary investments 9, 000Long-term investments 12, 000Accounts receivable 10, 000Inventories 18, 000Interest receivable 3, 000Prepaid insurance 1, 000Advances from customers 5, 000Income taxes payable 4, 000Accounts payable 15, 000Unearned rental income 8, 000Deferred income taxes 7, 000Cash surrender value of

Life insurance 20, 000

Required:(1) Compute the working capital of the Santos Company.(2) Compute the current ratio.(3) Compute the quick ratio.

6. The following accounts were taken from the records of the Demetrio Company:

Year 3 Year 4 Cash sales P300, 000 P350, 000Credit sales 600, 000 700, 000Sales discounts 20, 000 30, 000Sales returns and allowances 15, 000 18, 000Accounts receivable, beginning 40, 000 60, 000Account receivable, end 60, 000 80, 000

The sales discounts apply only to credit sales. Sales returns and allowances apply proportionately to cash sales and credit sales.

Required:(1) Determine the accounts receivable turnover for Year 3 and Year 4.(2) Determine the numbers of days’ in average receivables for both years assuming a 300 day (3) Determine the number of days’ sales in receivables at the end of each year.(4) 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 P600, 000 P720, 000 P900, 000Accounts receivable (net) 70, 000 90, 000 115, 000Allowance for bad debt 10, 000 15, 000 25, 000Sales discounts 5, 000 8, 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 60,000Direct labor 25,000 30,000Factory overhead 15,000 18,000 Total manufacturing costs P 90,000 P108,000Work in process inventory, beg. 18,000 24,000

P108,000 P132,000Work in process inventory, end 24,000 28,000Cost of goods manufactured P 84,000 P104,000Finished goods inventory, beg. 30,000 20,000Total goods available for sale P114,000 P124,000Finished goods inventory, end 20,000 22,000Cost 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 - 240,000Goods 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 P360,000Cost of goods sold 420,000Net credit sales 800,000Average raw materials inventory 40,000Average finished goods inventory 70,000Average accounts receivable 80,000

11. Data on net income, sales, and total assets for the Excelsior Co. are given below.

Year 7 Year 8Net income P 112,000 P 116,480Sales 1,400,000 1,820,000Total assets, beginning of year 490,000 510,000Total assets, end of year 510,000 530,000

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:

10% Preferred stock P 500,000Common stock, P20 par 1,000,000Retained earnings 150,000 Total 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.

(3) Price-earnings ratio.(4) Dividend-payout ratio.(5) Dividend yield on common stock.(6) 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 P100,0008%bonds payable 200,000Common stock 120,000 120,000Retained 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 P400,0008% Preferred stock 200,000Common stock 500,000Retained earnings 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) Sale of marketable securities at a gain.(2) Payment on accounts payable (assume a ratio of at least 1:1 before the payment).(3) Collection of accounts receivable at a discount.(4) 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 Ratio(1) Issuance of long-term note in exchange for land. Debt ratio(2) Conversion of long-term debt into common stock. Debt-to-equity ratio(3) Purchase of treasury stock. Equity ratio(4) Appropriation of retained earnings. Book value per share(5) Declaration of cash dividends on cumulative preferred stock. Earnings per share(6) Purchase of merchandise on account. Quick ratio(7) Reclassification of long-term liability to current liability. Current ratio(8) Decrease in market price of stock. Price-earnings ratio(9) Increase in selling price of a company’s product. Gross profit rate

(10)Write-off of a patent. 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 20 timesRate of return on sales 14%Gross profit rate 40%Operating expense ratio 19%Times interest earned 21 timesMerchandise inventory 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 DataAs of December 31,

19B 19ACash P 75,000 P 35,000Accounts receivable (net) 225,000 200,000Merchandise inventory 270,000 210,000

Short-term marketable securities 40,000 20,000Land and building (net) 500,000 500,000Mortgage payable-current portion 30,000 25,000Accounts payable and accrued liabilities 120,000 110,000Short-term notes payable 50,000 70,000

Year Ended December 3119B 19A

SalesCost of goods sold P1, 500, 000 P1, 300, 000

900, 000 800, 0001. Armando’s quick (acid test ratio) as of December 31 19B isa. 3.6 to 1b. 3.1 to 1c. 2.0 to 1d. 1.7 to 1 AICPA

2. Based on a business year consisting of 300 days, what was the number of days’ sales in average inventory for 19?

a. 80b. 70c. 54d. 48

19. Wal Corporation’s books disclosed the following information as of and for the year ended December 31, 19A:

Net credit sales P3, 000, 000Net cash sales 480, 000Accounts receivable at beginning 400, 000Accounts receivable at end 800, 000

Wal’s accounts receivable turnover isa. 3.75 timesb. 4.35 timesc. 5.00 timesd. 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. 4.0b. 4.4c. 5.0d. 5.5 AICPA

21. Selected information from the accounting records of Dalton Manufacturing Company is as follows:

Net sales P1, 800, 000Cost of goods sold for 19B 1, 200, 000Inventories at December 31, 19A 336, 000Inventories at December 31, 19B 288, 000Assuming there are 300 working days per year, what is the number of days’ sales in average

inventories for 19B?a. 78b. 72c. 52d. 48

AICPA

22. Selected information for Carmen Corp. For the year ended December 31, 19A follows:

Average days’ sales in inventories 124Average days’ sales in accounts receivable 48

The average number of days in the operating cycle for 19A wasa. 172b. 124c. 86d. 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 1b. 3.5 to 1c. 4. 8 to 1e. 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 P4, 500, 000Net income year ended 12/3 1/19B 1, 200, 000Dividends on preferred stock year ended 12/31/19B 300, 000Market price per share of common stock at 12/31/19B 72

The price-earnings ratio on common stock at December 31, 19B wasa. 5 to 1b. 6 to 1c. 8 to 1f. 9 to 1 AICPA

25. The following data are available:

Apex CorporationSELECTED FINANCIAL DATA

YEAR ENDED DECEMBER 31, 19A

Operating income P900, 000Interest expense 100, 000Income before income tax 800, 000Income tax expense 320, 000Net income 480, 000Preferred stock dividends 200, 000Net income available to common stockholders’ P280, 000

Common stock dividends P120, 000

1. The times interest earned ratio isa. 2.8 to 1b. 4.8 to 1c. 8.0 to 1d. 9.0 to 1

2. The times preferred dividend earned ratio isa. 1.4 to 1b. 1.7 to 1c. 2.4 to 1d. 4.0 to 1 AICPA

26. For each of the following numbered items, you are to select the letter that indicates its effects on the corporation’s 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 Effect(1) Declarations of a cash dividend due in one month A. Reduces working capital

on preferred stock B. Increases working capital(2) Declaration and payment of an ordinary stock C. Reduces current ratio

dividend D. Increases current ratio(3) Receipt of a cash dividend, not previously recorded, E. Reduces the peso amount of

on stock of another corporation total capital stock(4) Passing of a dividend on preferred stock F. Increases the peso amount of(5) Receipt of preferred shares as a dividend on stock total capital stock

held as temporary investment. This was not a G. Reduces total retained

regularly recurring dividend earningsH. increases total retained EarningsI. Reduces equity per share

of common stockJ. 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 Ratio’s balance sheet. Amounts indicated by a question mark (?) can be calculated from the additional information given.

AssetsCash P25, 000Accounts receivable (net) ?Inventory ? Property, plant and equipment (net) 294, 000

P432, 000

Liabilities and Stockholders’ EquityAccounts payable (trade) P ?Income taxes payable (current) 25, 000Long-term debt ?Common stock 300, 000Retained earnings ?____

Additional information:Current ratio (at year end) 1.5 to 1Total liabilities divided by total stockholders’ equity .8Inventory turnover based on sales and ending inventory 15 timesInventory turnover based on cost of goods sold and

ending inventory 10.5 timesGross margin for 19A P315, 000

(1) What was Ratio’s December 31, 19A balance in trade accounts payable?a. P67, 000b. P92, 000c. P182, 000d. P207, 000

(2) What was Ratio’s December 31, 19A balance in retained earnings?a. P60, 000 deficitb. P60, 000c. P132, 000 deficit

d. P132, 000

(3) What was Ratio’s December 31, 19A balance in the inventory account?a. P21, 000b. P30, 000c. P70, 000d. P135, 000

AICPAPROBLEMS

3.1 Presented below are the income statements of the Amex Co. for the years ended December 31 19C and 19D.

19C 19DGross sales P245, 000 P260, 000

Sales returns and allowances 4, 000 3, 000Net sales P241, 000 P257, 000 Cost of goods sold 135, 000 132, 000Gross profit P106, 000 P125, 000Operating expenses:

Selling 35, 000 40, 000General and administrative 28, 000 23, 000

Total operating expenses 63, 000 63, 000 Operating income P 43, 000 P 62, 000Interest expense 2, 000 3, 000Net income before income tax P 41, 000 P 59, 000Income tax 12, 000 17, 000Net income P 29, 000 P 42, 000

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 19BAssets

Current assets P540, 000 P520, 000Investments 300, 000 310, 000Plant assets, net 960, 000 940, 000Intangible assets 150, 000 120, 000Other assets 80, 000 100, 000

Total assets P2, 030, 000 P1, 990, 000

LiabilitiesCurrent liabilities P230, 000 P245, 000Long-term liabilities 300, 000 400, 000Other liabilities 70, 000 50, 000

Total liabilities P600, 000 P695, 000Stockholders’ Equity

Preferred stock P300, 000 P300, 000Common stock 500, 000 600, 000Additional paid-in capital 50, 000 60, 000Retained earnings 580, 000 335, 000

Total stockholders’ equity P1, 430, 000 P1, 295, 000Total liabilities and stockholders’ equity P2, 030, 000 P1, 990, 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 CompanyBalance Sheet

December 31, Year 5

AssetsCash P65, 000Marketable securities 24, 000Accounts receivable (net) 35, 000Raw materials inventory 40, 000Work in process inventory 18, 000Finished goods inventory 70, 000Prepaid expenses 14, 000Property, plant, and equipment (net) 640, 000

Total assets P906, 000

LiabilitiesAccounts payable P45, 000Accrued expenses 36, 000Income taxes payable 26, 000Cash dividends payable 20, 00012% Bonds payable 200, 000Deferred income taxes 30, 000

Total liabilities P357, 000

Stockholders’ Equity

Common stock P360, 000Additional paid-in capital 42, 000Retained earnings 147, 000

Total stockholders’ equity 549, 000Total liabilities and stockholders’ equity P906, 000

Winston CompanyIncome Statement

For the Year Ended December 31, Year 5

Sales P975, 000Less Sales discounts P15, 000

Sales returns and allowances 20, 000 35, 000Net sales P940, 000Less cost of sales:

Raw materials inventory, Jan. 1 P30, 000Purchases 268, 000Materials available for use P298, 000Raw materials inventory, Dec. 31 40, 000

Raw materials used P258, 000Direct labor 226, 000Factory overhead 163, 000

Total manufacturing costs P647, 000Work in process inventory Jan. 1 16, 000Total goods placed in process P663, 000Work in process, Dec. 31 18, 000Cost of goods manufactured P645, 000Finished goods inventory, Jan. 1 75, 000Total goods available for sale P720, 000Finished goods inventory, Dec. 31 70, 000

Cost of goods sold P650, 000Gross profit on sales P290, 000Operating expenses 140, 000Operating income P150, 000Other revenues and expenses (net) 35, 000Income before income taxes P185, 000Net income 65, 000

P120, 000Required: 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 19BIncome statement data:

Net sales P1, 200, 000 P1, 500, 000Cost of goods sold 600, 000 825, 000Operating income 252, 000 285, 000Net income before taxes 120, 000 140, 000Net income 90, 000 105, 000

Balance sheet data:Total liablilities P 400, 000 P 175, 0006% Preferred stock 200, 000 200, 000Common stock 225, 000 400, 000Retained 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 CompanyBalance Sheet

December 31, 19C

Assets Cash P 105,000Marketable securities 140,000Accounts receivable 75,000Inventories 170,000Prepaid expenses 45,000Land 150,000Building (net) 240,000Equipment (net) 160,000Other assets 80,000

Total assets P1,165,000

Liabilities and Stockholders’ Equity

Accounts payable P 149,000Notes payable 173,000Accrued expenses 147,00012% Bonds payable 150,0008% Preferred stock 100,000Common stock 200,000Retained earnings 246,000

Total liabilities and stockholders’equity P 1,165,000

Warlito CompanyStatement of Income and Retained Earnings

For the Year Ended December 31, 19C

Net sales P 600,000Cost of goods sold P 347,000Selling expenses 56,000General and administration expenses 32,000Internet expense 18,000

Total expenses P 480,000Income before income taxes P 120,000Income taxes 4,200Net income P 78,000Retained earnings, beginning of year 200,000

P 278,000Dividends – Preferred P 8,000

Common 24,000 32,000Retained earnings, end of year 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, 875,000Net income 190,000 160,000Total assets 1,330,000 1,210,000Market price of stock at year-end 60.00 25.00Cash dividends per share 3.00 1.20Liabilities 600,000 560,000Preferred stock 300,000 100,000Preferred dividends rate 8% 10%Common stock 200,000 300,000Paid-in capital in excess of par-common 50,000 40,000Retained earnings 180,000 210,000Common 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 December 31

Net sales P28, 000 P280, 000Cost of goods sold 190, 000 200, 00Gross profit P 70, 000 P 80, 000Operating expenses 30, 000 45, 000Operating income P 40, 000 P 35, 000

Interest expense (10, 000) (10, 000)Interest income 4, 000 3, 000 Income before income taxes P 34, 000 P 28, 000Income taxes 6, 000 5, 000Net income P 28, 000 P 23, 000

Balance SheetDecember 31

Assets 19A 19BCash P42, 000 P60, 000Trade receivables (net) 45, 000 70, 000Inventories 80, 000 85, 000Prepaid expenses 25, 000 30, 000Plant and equipment (net) 680, 000 690, 000Intangibles 80, 000 110, 000Other assets 25, 000 35, 000

Total assets P977, 000 P1, 080, 000

EquitiesAccounts and notes payable P48, 000 P72, 000Accrued expenses 30, 000 38, 000Income taxes available 47, 000 49, 000Cash dividends payable 55, 000 65, 00010% Bonds payable 100, 000 100, 0006% Preferred stock, cumulative,

P100 par and liquidating value 150, 000 150, 000Common stock, P25 par 250, 000 300, 000Additional paid-in capital 120, 000 124, 000Retained earnings 177, 000 182, 000

Total equities P977, 000 P1, 080, 000

Required:

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 day’s sales in trade receivables at the end of each year( assume a 360-day

business year)(e) Inventory turnover(f) Number of day’s 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 P210, 000Tax rate 30%Rate of return on total assets (based on ending balance) 21%Gross profit rate 45%Assets turnover rate 1.75%Equity ratio .60%Ratio of current assets to total assets .30%Current ratio 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 Corporation’s management is concerned over the corporation’s 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 P223, 050Less current assets:

Cash P 5, 973Accounts receivable (net) 70, 952Inventory 113, 125 190, 050

Working capital deficit P33, 000

Lucid CorporationIncome statement

For the Year December 31, 19A

Sales (90, 500 units) P760, 200Cost of goods sold 452, 500Gross profit P307, 700Selling and general expenses, including

Depreciation of P22, 980 155, 660Income before income tax P152, 040Income tax 68, 418Net income 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).

Fixed Variable costsCosts per unit__

Cost f goods sold P 4.90Selling and general expenses, including

Depreciation of P15, 450 P129,720 _1.10 Total P129,720 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 management’s 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 yearAcid-test ratio 2 to 1Current ratio 3 to 1Quick asset composition: 8% cash, 32% marketable

Securities, 60% accounts receivableAsset turnover 2 per yearRatio of total assets to intangible assets 20 to 1Ratio of accumulated depreciation to

Cost of fixed assets 1 to 3

Ratio of accounts receivable to accountsPayable 1.5 to 2

Ratio of working capital to stockholders’Equity 1 to 1.6

Ratio of total liabilities to stockholders’Equity 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 Harvest’s financial statements (ignoring income tax). Major captions appearing on Golden Harvest’s 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 P160, 000Less preferred dividends

(P1, 000, 000 x 6%) 60, 000Net income applicable to common P100, 000Divide by number of common shares

outstanding 50, 000Earnings per share P 2.00

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.

To illustrate, assume the following changes in the number of shares of common stock outstanding of a business:

January 1 Outstanding, 10, 000 shares of common stockApril 1 Issued 2, 000 shares of common stockAugust 1 Issued 3, 000 shares of common stockOctober 1 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 - Dec. 31 10, 000 x 12/12 = 10, 000April 1 - Dec. 31 2, 000 x 9/12 = 1, 500Aug. 1 - Dec. 31 3, 000 x 5/12 = 1, 250Oct. 1 - Dec. 31 2, 000 x 3/12 = ( 500)

Weighted average number ofshares outstanding 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 - Mar. 31 10, 000 x 3/12 = 2, 500April 1 - July 31 12, 000 x 4/12 = 4, 000Aug. 1 - Sept. 31 15, 000 x 2/12 = 2, 500Oct. 1 - Dec. 31 13, 000 x 3/12 = 3, 250 Weighted average number of

shares outstanding 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 Issued 12,000 shares of common stockMay 1 Issued 3,000 shares of common stockDec. 1 Issued a 25% stock dividendDec.31 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 = 15,000May 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 = 37,500June 1 Issued a 2-for1 stock splitDec. 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 = 37,500March 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 = 30,000May 1 – Dec. 31 3,000 x 1.25 x 2 x 8/12 = 5,000

Weighted average of current equivalentShares 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 P600,000

Extraordinary gain, net income tax __75,000Income before cumulative effect of a

change in accounting principle P675,000Cumulative effect of a change in

accounting principle, net of tax _(50,000)Net income 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 P10.80

Extraordinary gain 1.50Cumulative effect of a change in

accounting principle _(1.00)Net income P11.30

---------

The computations are:

Income before extraordinary item P600,000Less preferred dividends

(P1,000,000 x 6%) __60,000Income before extraordinary item

applicable to common P540,000

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

Earnings per share:Income before extraordinary item

(P540,000 + 50,000 shares) P10.80Extraordinary item

(P75,000 + 50,000 shares) 1.50Cumulative effect of change in

accounting principle(P50,000 + 50,000 shares) _(1.00)

---------Complex capital structure

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 PxxxExtraordinary item xxxNet income Pxxx

------Earnings per common share-assuming full dilution:

Income before extraordinary item PxxxExtraordinary item _xxxNet income 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 securities2) Options and Warrants3) Two-class common stock and participating securities4) 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.

66 2/3% of AaSecurity Cash Yield Corp. Bond Yield

1) 7% convertible bond _17_= 6.67% 2/3 x 12 = 8%P105

2) 8% Convertible pref.Stock _P8_= 8.00% 2/3 x 12 = 8%

P1003) 6% Convertible bond _P6_=6.32% 2/3 x 9 = 6%

P 95

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, 000Net income for 19A P400, 000Income tax rate 40%

The earnings per shares without the convertible bond is:

Actual net income P400, 000Number of shares outstanding 100, 000Earnings per share (P400, 000 ÷ 100,000) P4.00

The convertible bond is a common stock equivalent because its cash yield of 6% is less than two-thirds 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 P400, 000Add: interest expense, net of tax

(P500,000 x 6% x 6-%) 18,000Adjust net income P418, 000

Actual number of shares outstanding 100,000Add shares issued upon assumed conversion of bonds (P500,000 + P1,000 x 20 shares) 10,000Adjust number of shares 110,000

Primary earnings per square (P418,000 ÷ 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 P400, 000Add: interest expense, net of tax

(500,000 x 15% x 60%) 45,000Adjust net income P445, 000

Adjusted number of shares (same as above) 110,000Primary 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 P400, 000Add: interest expense, net of tax

(P500,000 x 5% x ¾ year x 60%) 13,500Adjusted net income P413, 500

Actual shares outstanding 100,000Add shares issued upon assumed conversion of

bonds (P500,000 ÷ P1,000 x 20 = 10,000 x 3/4) 7,500Adjusted number of shares 107,500

Primary earnings per share (P413, 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 P412,000Actual number of shares outstanding:

Jan. 1 – Dec. 31 – 100,000 x 12/12 100,000

May 1 – Dec. 31 – 10,000 x 8/12 6,667Average shares outstanding 106,667

Earnings per share (P412, 000 ÷ 106,667) P3.86The earnings per share assuming conversion took place at the beginning of the year is:

Actual net income P412, 000Add: interest expense, net of tax

(P500, 000 x 6% x 4/12 x 60%) 6,000Adjusted net income P418, 000

Actual number of shares outstandingJan. 1 – Dec. 31 – 100,000 x 12/12 100,000May 1 – Dec. 31 – 10,000 x 8/12 6,667

Shares issued upon assumed conversion of bonds(P500, 000 ÷ P1, 000 x 20 = 10,000 x 4/12) 3,333

Adjusted number of shares 110,000

Primary earnings per share (P418, 000 ÷ 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 P400, 000Less preferred dividends

(P500,000 x 6%) 30,000Income applicable to common P370, 000Dividend by average number of shares outstanding 100,000Earnings per share 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 100,000Shared issued upon assumed conversion of preferred stock

(5,000 shares x 4) 20,000Adjusted number of shares 120,000

Primary earnings per share (P400, 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 50,000Options outstanding during the year 5,000Exercise price per share of common stock P4Average market price of common stock 5Net income for the year P75, 000

The earnings per share without the option is:

Net income P75, 000Actual number of shares outstanding 50,000Earnings per share (P75, 000 ÷ 50,000) P1.50

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 50,000Add incremental shares:

Shares issued on assumed exercise of options 5,000Less assumed repurchase of shares from

proceeds of options (5,000 shares x P4 = P20,000 ÷ P5) 4,000 1,000Adjusted number of shares 51,000

Primary earnings per share (P75, 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 8,000Options outstanding 4,000Exercise price P3Average market price of stock P410% Bonds payable P20, 000

Net income for the year P30,000

Income tax rate 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 P30, 000Actual number of shares outstanding 8,000Earnings per share (P30,000 ÷ 8,000) P3.75

The primary earnings per share is computed as follows:

Proceeds from assumed exercise of options (4,000 x P3) P12, 000Less proceeds applied to repurchase of

outstanding shares – 8,000 x 20% x P4 6,400Balance applied to retirement of bonds P5, 600

Actual net income P30, 000Add: Interest, net of tax

(P5, 600 x 10% x 60%) 336Adjusted net income P30, 336

Actual number of shares outstanding 8,000Add incremental shares:

On assumed exercise of options 4,000Less assumed repurchase of shares 1,600 2,400

Adjusted number of shares 10,400

Primary earnings per share (P30, 336 ÷ 10,400) P2.92

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 earnings3) The attainment of some levels of earnings4) Changes in the market prices which modify the number of shares to be issuedIf 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 P400, 00015-year, 9% convertible bonds P600, 000Common shares outstanding

(no change during year) 100, 000Options outstanding during year P300, 000Income tax rate 40%

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%.

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 P300, 000Add: Interest, net of tax

(P400, 000 x 7% x 60% ) 16, 000Adjust net income P316, 800

Actual shares outstanding P100, 000Shares issued on assumed conversion of

7% bonds (P400, 000 ÷ P1, 000 x 80) 32, 000Shares issued on assumed exercise of options 10, 000Shares issued on assumed to be repurchased from proceeds

Of options (10, 000 x P4 ÷ 8) (5, 000)Adjusted number of shares 137, 000

Primary earnings per share (P316, 800 ÷ 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 P300, 000Add: interest on 7% bonds, net of tax

(P400, 000 x 7% x 60% ) 16, 800Interest on 9% bonds, net of tax(P600, 000 x 9% x 9/12 x 60%) 24, 300

Adjust net income P341, 100

Actual shares outstanding 100, 000Shares issued on assumed conversion of

7% bonds (P400, 000 ÷P1, 000 x 80) 32, 000Shares issued on assumed conversion of

9% bonds (P600, 000 ÷ P1, 000 x 100 x 9/12) 45, 000Shares issued on assumed exercise of options 10, 000Shares assumed to be repurchased from

proceeds of options (10, 000 x P4 ÷ P10) (4, 000)Adjusted number of shares 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 liquidatingvalue, P100; issued, 10, 000 shares P1, 000, 000

Common stock, par value, P100; issued,5, 000 shares 500, 000

Retained earnings 300, 000Total stockholders’ equity P1, 800, 000

Preferred stock is noncumulative, nonparticipating

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 P1, 800, 000Less equity applicable for preferred:

Liquidation value, 10, 000 shares @ P100 P1, 000, 000

Dividends in arrears,P1, 000, 000 x 6% x 3 years 180, 000 1, 180, 000

Equity applicable to common P 620, 000

Book values per share:Preferred - P1, 180, 000 ÷10, 000 shares P118.00Common – P620, 000 ÷5, 000 shares 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 1, 180, 000Less equity applicable to preferred:

Liquidation value, 10,000 sharesAt P100 P1, 000, 000

Current dividends and retainedEarnings in participationWith common (see below) 200, 000 1, 200, 000

Equity applicable to common P 600, 000

Distribution of retained earnings:Preferred Common Total

Current dividends:Preferred –P1, 000, 000 x 6% P60, 000Common-P500, 000 x 6% P30, 000 P90, 000

Balance distributed ratably:Preferred – P1, 000, 000 x P210, 000 140, 000

P1, 500, 000Common – P500, 000 x P210, 000 70, 000 210, 000

P1, 500, 000Total P200, 000 P100, 000 P300, 000

Book values per share:Preferred – P1, 200, 000÷10, 000 shares P120.00Common – P600, 000÷5, 000 shares 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. 1 Balance: 40,000 sharesMarch 31 Issued 3,000 sharesJuly 1 Issued 5,000 sharesAug. 30 Issued a 25% stock dividendSept. 30 Issued a 2-for-1 stock splitDec. 1 Required 12,000 shares of common stock

Required: Compute the weighted average number of shares outstanding.

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 P250,000Preferred stock, P25 par, convertible.

issued and outstanding, 5,000 shares 125,000Common stock, P10 par, issued and outstanding,

30,000 shares 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 P100,000Income taxes expense 40,000Income before extraordinary item P 60,000Extraordinary loss, net of tax of P7,000 20,000Net income P 40,000

-----------

7% preferred stock, P100 par P100,000Common stock, P10 par 250,000

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 effectof change in accounting principle P180,000

Extraordinary item-gain on extinguishment of long-termdebt (less applicable income taxes of P22,500) 75,000

Cumulative effect of a change in accounting principle(less applicable income tax of P9,000) (30,000)

Net income P225,000 ------------

Balance sheet data:

10% Cumulative preferred stock P300,000Common stock, P50 par 500,000

Additional information:(1) The preferred stock is not convertible into common stock.

(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) A 5% nonconvertible bond sold at its par value of P100. The average Aa corporate bond yield at time of issuance was 9%.

(b) A convertible 6% preferred stock, par value, P100, sold at par. The average Aa corporate bond yield at time of issue was 12%.

(c) A convertible, 12% bond sold at face value. The average Aa corporate bond yield at time of issue was 18%.

(d) A convertible, 9% bond, sold at 96. The average Aa corporate bond yield at time of issue was 14%.

(e) A convertible, 8% bond, sold at 105. The average Aa corporate yield at time of issue was 12%.

(f) 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.

(g) Warrants to acquire 2,000 shares of common stock at P10 per share. The average market price of common stock was P8 per share.

(h) 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.

(i) 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 Company’s balance sheet December 31, Year 8 contained the following information:

12% Nonconvertible bonds P 800,000Convertible, 10% Preferred stock, P100 par 1,000,000Nonconvertible, 12% Preferred stock, P25 par 1,250,000

Common stock, P50 par P2,875, 000Additional paid-in capital 1,250, 000Retained earnings 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 P250,000Premium on common stock 50,000Retained 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 P1,000,000Common stock subscribed 250,000Additional paid-in capital 100,000Retained earnings 600,000Treasury 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 Company’s balance sheet as of December 31, 19D was as follows:

10% Preferred stock, P100 par value,Authorized, 10,000 shares, issuedAnd outstanding, 5,000 shares P 500,000

Common stock, P10 par value, authorized100,000 shares, issued and outstanding,80,000 shares 800,000

Additional paid-in capital 300,000Retained earnings 400,000

Total stockholders’ equity 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 Par’s 19B earnings per common share?

a. P1.30b. P1.70

c. P1.80d. 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. P10.00b. P9.50c. P9.00d. 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. Randy’s earnings per share for 19A are

a. P1.86b. P2.10c. P2.84d. 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. 306,000b. 309,000c. 324,000d. 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 Peran’s primary earnings per share for 19B?

a. P1.50b. P2.25c. P2.50

d. P3.75AICPA

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 Manny’s 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. 325,000b. 335,000c. 360,000d. 365,000

AICPA

19. Information relating to the capital structure of Paramount Corporation is as follows:December 31

19A 19BOutstanding shares of:

Common stock 90,000 90,000Preferred stock, convertible into

30,000 shares of common 30,000 30,00010% 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. Paramount’s 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 isa. P10.89b. P10.39c. P8.17d. P7.79

2. For the year ended December 31, 19B, the fully diluted earnings per share isa. P9.82b. P8.29c. P7.71d. 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. 735,000b. 780,000c. 885,000d. 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. P12.00b. P11.95c. P11.90d. P11.85

AICPA

22. Florante, Inc. Was organized on January 2, 19A, with the following capital structure:

10% cumulative preferred stock, par valueP100 and liquidation value P105; authorized, issued, and outstanding 1,000 shares P100,000

Common stock, par value P25; authorized100,000 shares; issued and outstanding10,000 shares P250,000

Florante’s net income for the year ended December 31, 91A was P450,000, but no dividends were declared.

1. How much was Florante’s book value per preferred share at December 31, 19A?a. P100b. P105c. P110d. P115

2. How much was Florante’s book value per common share at December 31, 19A?a. P45.00b. P68.50c. P69.50d. P70.00

AICPA

PROBLEMS4.1 Fajela Co. Had the following transactions involving its common stock during 19C and 19D:19CJan. 1 Balance: 10,000 shares of common stock with stated value of P20 per shareApril 30 Issued a 15% stock dividendOct. 1 Issued 2,000 shares of common stock at P22Nov. 30 Split its common stock on a 2-for-1 basis

19DJune 30 Sold 3,000 shares of common stock at P23Aug. 30 Reacquired 2,000 shares of common stockSept. 30 Split common stock on a 3-for01 basisNov. 1 Sold 3,000 shares of treasury stock for P25Dec. 1 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:

19AJan. 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.May 1 Sold 6,000 shares of common stock for P12 per share Nov. 1 Issued a 10% stock dividend on common stock. The market price of the common

stock was P14 per share.Dec. 31 Reported a net income of P125,000 during the year.

31 Paid 8% cash dividend on the preferred stock.

19BMarch 1 Sold 2,000 shares of preferred stock at parJuly 1 Split common stock on a 2-for-1 basisSept. 1 Purchased 12,000 shares of common stock at P6 per share to be held as treasury stock.Nov. 1 Sold 3,000 shares of treasury stock for P8.00 per shareDec. 31 Reporting a net loss of P48,000 for 19B.

Required: Compute the following for 19A and 19B:(1) Weighted average of equivalent common shares(2) Earnings per common share(3) Book value per share of preferred stock.(4) 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, authorized 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 5,000,000

Retained earnings 2,000,000 Total stockholders’ equity P8,000,000

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

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

19BApril 1 Sold 40,000 shares of common stock at 105.Oct. 1 Repurchased 5,000 shares of common stock at 110Dec. 31 Paid cash dividends of 6% on preferred stock and issued a 25% stock dividends on

common stock31 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 Year 4

Income from continuing operations P700, 000 P750,000Discontinued operations: Income from operation of discontinued

Division, net of tax of P27, 000 inYear 3 and P24, 000 in year 4 63, 000 56, 000

Loss on disposal of discontinuedDivision, net of tax of P12, 000 ________ (28, 000)

Income before extraordinary item anCumulative effect of change in Accounting principle P763, 000 P778, 000

Extraordinary loss, net of tax of P16, 000 (42, 000)Cumulative effect of change in accounting

Principle, net of tax of P6, 000 _________ 14, 000Net income P721, 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 – P300,00019B – P240,00019C – (150,000)19D – P380,00019E – 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 Date Issue Aa CorpAmount issued price bond yield

(a) 10 year, 6% convertiblebond, each P1,000 bond convertible into 40 shares P400,000 5/1//19C 100 9%

(b) 15 year, 8% convertible Bond P600,000 1/1/19D 106 12%

(c) 20-year, 10% convertible

bond, each P1,000 bondconvertible 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 70,000Net income for 19D P117,000Income tax rate 35%

Required: Compute the following earnings per share for 19D:(a) Primary earnings per share(b) Fully diluted earnings per share

4.7 The following data were taken from the balance sheet of the Gorospe Company at Decemberm31, 19F:

15-year, 14% convertible bonds P 500,0008% cumulative, convertible

preferred stock, par value, P50 per share 1,500,000

Common stock, par value, P10 per share 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 P400,000Common shares outstanding (no change

during year) 30,0006% Convertible bonds (common stock

equivalent) P200,000Conversion term of bonds 20 shares per P 1,000 bondOptions outstanding during the year 5,000Exercise price per share on options P18Average market price per common share P20Ending market price per common share P25Income 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 P250,000Common stock, P10 900,000Paid-in capital 300,000Treasury stock, 10,000 shares at cost 180,000

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.

4.10 The records of the Nicolas Co. on December 31, 19C show the following information:

10-year, 12% convertible bond s P200,00020-year, 10% convertible bonds P300,0006% Preferred stock, P100,000 par,

cumulative, nonconvertible P400,000Common stock, P25 par P600,000Common stock warrants outstanding 5,000Net income for 19% P108,000Tax rate 40%

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.

(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 P250,000

Common stock, P25 par, authorized, 50,000 shares, issued and outstanding, 20,000 shares 500,000

Additional paid-in capital 75,000Retained earnings P125,000

Total stockholders’ equity 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 Corporation’s capital structure is as follows:

December 3119B 19A

Outstanding shares of:Common stock 336,000 300,000Nonconvertible preferred stock 10,000 10,000

8% convertible bonds P1,000,000 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 Hulog’s 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) Hulog’s 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 costs3. Fixed costs4. Sales volume5. 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 line2) Plot the variable costs on top of the fixed costs to obtain the total cost line3) Plot the revenue line4) Determine the break-even point

To illustrate the construction of a break0even chart, assume the following data:Selling price per unit P4.00Variable cost per unit 2.00Total fixed costs P10,000.00Sales 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. 5.1Break-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 approachAn 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. 5.2Break-even chart

Assumption of cost-volume-profit analysisThe 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 cost-volume-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 consumptionsWhen 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 approachThe equation of the break-even point may be developed algebraically by defining the following

symbols:y = total revenue or costp = selling price per unit

v = variable cost per unitp – v = unit contribution margin

Fig. 5.3Break-even Chart

TFC = total fixed costx = volume, in unitsBEP = 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 = pxFor the total cost, the equation is

y = TFC + vxSince 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 p – v

Thus, the equation of the break-even point isBEP (in units) = Total fixed costs___

Unit contribution marginApplying 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 pointTFC = total fixed costsVC = variable costs S = salesVC = 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, 000The 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 capacityWhere BEP = break-even point

TFC = total fixed costsp-v = unit contribution margin

Using the above formula, the break-even point for the given data isBEP (in % of capacity) = ____P10, 000___

(P4 – P2) x 10, 00050%

Calculating profit at any volumeThe profit or loss at any volume can be obtained algebraically from the following formula:

P = px – vx – TFCWhere P = profitpx = total salesvx = total variable costsTFC = total fixed costs

The profit, for example, at 6, 000 units based on the given facts, is calculated as follows:

P = 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.

C-V-P Income Statement

Sales P24, 000Less variable costs 12, 000Contribution margin P12, 000Less fixed costs 10, 000Net income 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)

P(10, 000 units) = P4 (10, 000) – P2(10, 000) – P10, 000= P10, 000

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 salesActual 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, 000P32, 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 = S x P/V ratio x M/S ratio

Where P = profitS = actual budgeted sales

P/V ratio = contribution margin ratio M/S 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) = TFC ---_Desired profitUnit contribution margin

OrDesired sales (in pesos) = TFC ---_Desired profit

Contribution margin ratio

If desired profit is after taxes, the equations are:

= TFC ---_Desired profit (after tax)Desired sales (in units) 1 - Tax rate

Unit contribution marginOr

= TFC ---_Desired profit (after tax)Desired sales (in pesos) 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, 0001- .40

P2= 7, 500 units

Sensitivity analysis

Cost-volume-profit relationships can be utilized to determine the effect on profit or the break-even 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) Changes in the selling price2) Changes in the variable costs3) Changes in fixed costs4) Changes in volume

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

Selling price are assumed per unit P10Variable cost per unit 6Total fixed costs P20, 000Current sales volume 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.

IncreasePresent Proposed (Decrease)

Sales – 10, 000 x P10 P100, 000 -10, 000 x P12 P120, 000 P120, 000Less variable costs 60, 000 60, 000 _______0Contribution margin P 40,000 P 60, 000 P 20, 000Less fixed costs 20, 000 20, 000 _______0Net income P 20, 000 P 40, 000 P 20, 000

------------- ------------- --------------P/V ratio 40% 50%Break-even point P 50, 000 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. 5.5P/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 0Less variable costs –

10, 000 x p6.00 60, 00010, 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 _________0Net 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. 5.6P/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.

IncreasePresent Proposed (Decrease)

Sales P100, 000 P100, 000 P 0Less variable costs 60, 000 60, 000 0Contribution margin P 40, 000 P 40, 000 P 0Less fixed costs ___20, 000 ___30, 000 10, 000Net income P 20, 000 P 10, 000 P (10, 000)

------------- -------------- ----------------P/V ratio 40% 40%Break-even point P 50, 000 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. 5.7P/V Graph

Change in volume

Assume that volume will increase by 50%. The increase in volume will have the following effects:

IncreasePresent Proposed (Decrease)

Sales – 10, 000 x P10 P100, 00019, 000 x P10 P150, 000 P 50, 000

Less variable costs-10, 000 x P6 60, 00015, 000 x P6 ________ 90, 000 30, 000

Contribution margin P 40, 000 P 60, 000 p 20, 000Less fixed costs 20, 000 20, 000 0Net income P 20, 000 P 40, 000 P 20, 000

-------------- --------------- ---------------P/V ratio 40% 40%Break-even point P 50, 000 P 50, 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 Profit P/V ratio BEP1. Selling price:

Increase Increase Increase DecreaseDecrease Decrease Decrease

Increase2. Variable costs;

Increase Decrease Decrease IncreaseDecrease Increase Increase Decrease

3. Fixed costs:Increase Decrease No effect IncreaseDecrease Increase Increase Decrease

4. Volume:Increase Increase No effect No effectDecrease Decrease No effect No effect

Multiple changes

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.

IncreasePresent Proposed (Decrease)

Sales – 10, 000 x P10 P100, 00014, 000 x P8 P112, 000 P12, 000

Less variable costs-10, 000 x P6 60, 00014, 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 0Net 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, 000P2

= 20, 000 unitsThe 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 ProposedSales – 10,000 x P10 P100,000 20,000 x P8 P160,000Less variable costs – 10,000 x P6 60,000

-20,000 x P6 _______ 120,000Contribution margin P 40,000 P 40,000Less fixed costs __20,000 __20,000Net income P 20,000 P 20,000

----------- -----------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 1,800,000Less variable costs (P1,800,000 x 40%) 720,000Contribution margin P 1,080,000Less fixed costs 600,000Net income P 480,000

--------------The current break-even point is:

BEP = P600,000 60%

= P1,000,000If 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 P1,000,000Less variable costs 800,000 1,000,000 400,000Contribution margin P1,200,000 P1,800,000 P 600,000Less fixed costs 600,000 750,000 150,000Net 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%

= P1,250,000The volume of sales that the company must attain in order to maintain the same present profit is

Desired sales = P750,000 / P480,00060%

= P2,050,000If 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 P15Annual fixed costs P75,000Selling 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) P 180,000Less variable costs (6,000 x P15) 90,000Contribution margin P 90,000

Less fixed costs 75,000Net income 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.

Sales (6,600 x P30) P 198,000Less variable costs (6600 x P15) 99,000Contribution margin P 99,000Less fixed costs 75,000Net income 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:

% increase in profits = 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

Degree of operating leverage = P99,000P24,000

= 4.125The 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

% increase in profits = 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) P 217,800Less variable costs (7,260 x P15) 180,900Contribution margin P 108,900Less fixed costs 75,000

Net income P 33,900------------

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 marginProduct 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 Total Contribution Sales Contribution

Product margin___ mix margin___ X P6 4 P24 Y 4 6 24

10 P48Average contribution margin = P48

10= P4.80

The break-even point is thereforeBEP = 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 unitsProduct 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 Unit Unit Unit Contribution Volume selling variable Contribution margin

Product (units) price cost margin ratio A 6,000 P5 P2 P3 60% B 5,000 4 2 2 50

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 TotalSales P 30,000 P 20,000 P50,000Less variable costs 12,000 10,000 22,000 Contribution margin P 18,000 P 10,000 P28,000Less fixed costs 14,000Net income P14,000

-----------

Average contribution margin ratio = P28,000P50,000

= 56%

The break-even point is thusBEP = P14,000

56%= P25,000

The break-even sales can be broken down per product as follows:

Product A – P25,000 x 60% = P15,000Product B – P25,000 x 40% = 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 mixThe 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 Unit Unit Unit Contribution Volume Selling Variable contribution margin

Product (units) price cost margin ratio M 3,000 P20 P12 P8 40% N 2,000 10 7 3 30

Total fixed costs – P12,000The income of the company at the present sales mix is computed below.

Product M Product N Total Sales P 60,000 P 20,000 P 8,000Less variable costs 36,000 14,000 50,000Contributed 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 Product N Total_Sales P20,000 P40,000 P60,000Less variable costs 12,000 28,000 40,000Contributed margin P 8,000 P12,000 P20,000Less fixed costs 12,000

P 8,000 ----------

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) P 1,350,000Less cost of sales:

Variable costs (100,000 x P10) P 1,000,000Fixed costs (100,000 x P2) 200,000Total production cost P 1,200,000Less ending inventory

(10,000 units x P12) 120,000 1,080,00Gross profit on sales P 270,000Operating expenses:

Fixed P 50,000Variable 90,000 140,000

Net income 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 P 200,000Less fixed costs included in ending

inventory(10,000 x P2) 20,000Fixed manufacturing costs expensed P 180,000Fixed operating expenses 50,000Total fixed costs expensed during period 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) P 1,350,000Less cost of sales:

Variable production costs (100,000 x P10) P 1,000,000

Less ending inventory(10,000 units x P12) 100,000 900,000

Manufacturing margin P 450,000Less variable operating expenses (90,000 x P1) 90,000Contribution margin (90,000 x 4) P 360,000Les fixed expenses:

Fixed manufacturing expenses P 200,000Fixed operating expenses 50,000 250,000

Net income 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 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. What are the factors that affect the net income of a business?2. What basic assumptions are made in break-even analysis?3. State some applications of break-even analysis?4. What does a break-even graph show?5. Define the break-even point?6. What are the different ways in which the break-even point can be expressed?7. How are income taxes treated in the computation of the break-even point?8. Define contribution margin. How is the contribution margin ratio computed?9. What is the relationship of the contribution margin ratio and the variable cost ratio?10. What is the effect on the contribution margin ratio of a change in (a) volume? (b) fixed costs?11. What are the limitations of break-even chart?12. What does a profit-volume graph show? What is its advantage over a break-even point?13. What is the margin safety ratio? What is its significance?14. 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, 000Costs and expenses:

Variable P420, 000Fixed 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 BUnit sold 16, 000 20, 000Sales P64, 000 P80, 000Costs and expenses 40, 000 48, 000Net 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.

Required: (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%).

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 company’s 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 50, 000 unitsSelling price per unit P3.50 Variable costs per unit P2.10Total fixed costs P42, 000

Required: (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 P600,000Variable costs 450,000Contribution margin P150,000Fixed costs 90,000Net income P 60,000

------------ Required: Determine the expected profit under each of the following assumptions:

(a) Selling price is increased by 10%.(b) Variable costs are decreased by 15%.(c) Fixed costs are decreased by 25%.(d) Sales volume is increased by 20%.(e) Fixed costs are increased by 10% and selling price is increased by 5%.(f) Variable costs are increased by 10% and sales volume is increased by 20%.

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

Variable costs P4 per unitFixed costs 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: (1) Would it be advisable to decrease the selling price in accordance with the sales manager’s

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 Company YSelling price per unit P15 P12Variable costs per unit P 9 P 8Fixed costs P60,000 P48,000

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 P30.00Variable cost per unit P15.00Annual fixed costs P75,000.00

Required: (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 Product YSelling price per unit P7 P6Variable cost per unit 3 4

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 BSelling price per unit P5.40 P4.80Variable cost per unit 3.24 3.36

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 P3.00Fixed costs 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-volume-profit 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. 5,000b. 3,500c. 2,500d. 1,500

2. What total peso amount must Calica sell to break even?a. P 40,000b. P 75,000c. P 90,000d. 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__

Direct materials P1,600,000Direct labor 1,400,000Factory overhead 600,000 P 900,000Selling expenses 240,000 360,000Administrative expenses 60,000 140,000

P3,900,000 P1,400,000-------------- --------------

What would be the amount of sales pesos at the break-even point?a. P2,250,000b. P3,500,000c. P4,000,000d. P5,300,000

AICPA

24. Carreon Co.’s 19C operating percentages were as follows:

Sales 100%Cost of sales

Variable 50%Fixed 10 60

Gross profit 40Other operating expenses

Variable 20

Fixed 15 35Operating income 5%

-----

Carreon’s 19C sales totalled P2,000,000. At what 19C sales level would Carreon break even?a. P1,900,000b. P1,666,667c. P1,250,000d. 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. P400,000b. P251,000c. P231,000d. P200,000

AICPA26. Linda company reported the following results from sales of 5,000 units of Product A for the

month of June, 19A:

Sales P200,000Variable costs 120,000Fixed costs 60,000Operating income 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. 4,000b. 4,300c. 4,500d. 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 200,000 unitsSales 150,000 unitsSelling price P25.00 per unitVariable manufacturing costs P15.00 per unitFixed costs:

Manufacturing P800,000Selling and administrative 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. P100,000b. P200,000c. P300,000d. P550,000

AICPA

28. The following data pertain to two types of products manufactured by Corina Corp.:

Sales price per unit Variable costs per unitProduct Y P120 P 70Product Z 500 200

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 Corina’s break-even sales in units?a. 857b. 1,111c. 2,000d. 2,459

2. How much is Corina’s break-even sales in pesos?a. P300,00b. P420,000c. P475,000d. 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 P45,000Direct labor 36,000Factory overhead:

Variable 18,000Fixed 27,000

Selling and administrative (70% fixed) 30,000

Required: Determine the break-even point in (a) units of product, (b) peso sales.

5.2 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: (1) Compute the break-even point in (a) number of rooms rented, (b) percentage of occupancy.

(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 30,000 unitsBudgeted selling price P100.00

Variable costs Fixed costsCosts and expenses:

Direct materials P20Direct labor 18Factory overhead 15 60,000Selling expenses 5 120,000General and administrative 2 80,000

Required: 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 P5,000,000Costs and expenses:

Variable P3,000,000Fixed 1,000,000 4,000,000

Net income 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% andc. Increase in fixed costs by 25%.

5.6 The following statement has been prepared from the records of the Benjamin Co.:

Sales P900,000Costs and expenses:

Variable (40% of sales) P360,000Fixed 412,500 722,500

Net income 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 costsCost elements (percentage of sales) Fixed costs

Direct materials 30%Direct labor 20Factory overhead 8 P96,000Selling expenses 7 44,000Administrative expenses 5 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 company’s 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 P800,000Variable costs 540,000Contribution margin P260,000Fixed expenses 227,500Net income 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 A B C

Selling price per unit P6 P12 P10

Variable costs 5 9 8Total fixed cost P184,000

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 Product B Product CSales P120,000 P80,000 P200,000Variable costs 90,000 52,000 142,000Contribution margin (carried

forward) P30,000 P28,000 P 58,000

Contribution margin (broughtforward) P30,000 P28,000 P58,000

Fixed costs 43,500Net income P14, 500

----------

The actual sales for the budgeted year were as follows:Product A – P150, 000Product 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 P96, 000Cost of goods sold:

Beginning inventory P4, 000Manufacturing costs:

Variable P27, 000

Fixed 9, 000 36, 000P40, 000

Ending inventory 8, 000 32, 000Gross profit P64, 000Operating expenses:

Selling P28, 000Administrative 10, 000 38, 000

Net income P26, 000-----------

Data on physical quantities are as follows:Beginning inventory 1, 000Production 9, 000Total available 10, 000Ending inventory 2, 000Sales 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 STATEMENTFor the Year Ending December 31, 19B

Sales P10, 000, 000Cost of sales 6, 000, 000Gross margin 4, 000, 000Selling and administrative costs

Commissions P2, 000, 000All other costs (fixed) 100, 000 2, 100, 000

Income before income tax P 1, 900, 000Income tax 570, 000Net income 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 Seco’s 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 Seco’s 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.

AICPAChapter 6

Gross Profit Analysis

Gross Profit AnalysisThe 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 profitThe amount of gross profit is dependent on four factors, namely:1.) Selling Prices2.) Cost prices 3.) Sales volume 4.) Sales Mix

Sales mix, however, is a type of volume change. Thus, there are three main factors affecting grossprofit: 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 IncreaseNet Sales P200, 000 P242, 000 P42, 000Cost of Sales 150, 000 P173, 250 23, 250Gross Profit P 50, 000 P 68, 750 P18, 750

Units sold 2,000 2,200 200Selling price P100 P110 P10Unit cost P75 P78.75 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) P242,00019B sales at 19A prices

(2,200 units x P100) P220,000P 22,000

Increase in net sales due to increase in sales volume:19B sales at 19A prices

(2,200 units x P100) P220,00019A actual sales (2,000 units x P100) 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 Volume P200,000 Factor

P 20,000

Sales 0 2 ,000 2,200 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.

Increase in cost of goods sold due to increase in cost price: 19B actual cost of sales (2, 200 units x P78.75) P173,250 19A cost of sales as 19A costs

(2, 200 units x P75) 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) P165,000 19A actual cost of sales (2,000 units x P75) 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 P173,250 19B cost of sales at 19A costs 165,000 P8,250

Increase in cost of sales due to increase in sales volume: 19B cost of sales at 19A costs P165,000 19A actual cost of sales 150,000 15,000

Increase of cost of sales 23,250 Increase in gross profit P18,750

Procedures using quantities: Three-way analysisThe 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) 20,000Increase in net sales due to joint increase in price and increase in volume

(200 units x P10 ) 2,000Increase 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 ¦ Volume Price Factor- P20,000 ¦ price P2,000

¦ factor

P100 ----------

19A Sales Volume P200,000 Factor

P 20,000

Sales 0 2 ,000 2,200 Volume

Fig. 6.2 (units)

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) P7,500

` Increase in cost of sales due to increase in volume( 200 units x P P75 ) 15,000

Increase in cost of sales due to joint increase in cost price and increase in sales volume (200 units x P3.75) 750

Increase in cost of sales P23,250

A summary of the changes in net sales and cost of sales caused by price, volume, and volume-price factors is presented below.

Gross profit increased due to: Increase in net sales:

Price factor P20,000 Volume factor 20,000 Volume-price factor 2,000 P42,000

Less increase in cost of sales: Price factor P 7,500 Volume factor 15,000 Volume-price factor 750 23,250

Increase in gross profit P18,750

Chapter 7

Standard cost I

Standard cost, definedStandard 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 costsStandard 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 standardsStandards 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 standards2) Current attainable standards3) 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, and2. 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 are1) 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 toproducts. 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 capacity2) Practical capacity3) Normal capacity4) Expected actual capacity

Theoretical capacity is the volume of production which the business would attain if it operatescontinuously 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 capacityCapacity 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 costOverhead 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 80% 100% 120% Units of production 2,000 2,500 3,000 Labor hours 4,000 5,000 6,000

Variable Costs: Indirect Materials P2,800 P3,500 P4,200

Supplies 1,200 1,500 1,800 Power 2,400 3,000 3,600 Repairs and Maintenance 1,600 2,000 2,400 Total Variable Overhead ` P8,000 P10,000 P12,000Fixed Costs: Supervision P8,000 P8,000 P8,000 Depreciation 4,000 4,000 4,000 Insurance 2,000 2,000 2,000 Repairs and Maintenance 1,000 1,000 1,000 Total Fixed Overhead P15,000 P15,000 P15,000Total Factory Overhead P23,000 P25,000 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 hourFixed Overhead rate

(P15,000 / 5,000 hours) 3.00Total 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 CardA 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 SheetDirect Materials(10 units @ P.90) P9.00Direct Labor (2 hours @ P7.70) 15.00Factory Overhead:

Variable (2 hours @ P2.00) P4.00Fixed (2 hours @ P3.00) 6.00 10.00

Total standard cost P34.00

Variance ComputationA 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 variancesTwo variances can be computed for direct materials:

1) Materials price variance2) 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 P30,000Materials used 22,000 unitsUnits produced 2,400 units

Materials price varianceThe 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) P30,000

Actual quantity purchased x standard unit price(30,000 units x P0.90) 27,000

Materials price variance-unfavorable(30,000 units x P0.10) 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) P22,000

Actual quantity used x standard unit price(22,000 units x P0.90) 19,800

Materials price variance-unfavorable(22,000 units x P0.10) P 2,200

Materials quantity varianceThe 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) P19,800Standard quantity allowed x standard unit price

(24,000 units x P0.90) 21,600Materials 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 varianceFor direct labor, the two variances are:1) Labor rate variance2) Labor efficiency variance

To illustrate, assume the following data on actual labor costs for the Aurora Corp.Actual hours worked 4,600 hoursActual labor rate paid P7.75 per hour

Labor rate varianceThe labor rate variance is computed as follows:Actual hours worked x actual rate

(4,600 hours x P7.75) P35,650Actual hours worked x standard rate

(4,600 hours x P7.50) 34,500Labor rate variance- unfavorable

(4,600 hours x P0.25) 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 varianceThe 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) P34,500

Standard hours allowed x standard rate(4,800 hours x P7.50) 36,000

Labor efficiency variance- favorable(200 hours x P0.25) (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 varianceThe 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 method2) Three-variance method3) Four-variance method

To illustrate, assume the following data for the Aurora Corporation.Actual factory overhead:

Variable P10,000Fixed 15,000

All other facts assumed in the preceding examples remain unchanged.

Two-variance methodThe two variances under this method are:

1) Controllable or budget variance

2) Volume or capacity varianceThe 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 P25,000Budget allowance based on standard hours allowed (4,800 hours):

Variable (4,800 hours x P2.00/hour) P9,600Fixed 15,000 24,600

Controllable variance P 400

The budgeted allowance consists of the sum of the variable and the fixed overhead. The budgetedvariable 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 varianceThe 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) P24,600Factory overhead applied (4,800 hours x P5.00/hour) 24,000Volume variance-unfavorable 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 P5,000Standard hours allowed 4,800Unutilized hours 200Fixed overhead rate per hour P3Volume variance-unfavorable 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 variance2) Variable efficiency variance 3) Volume variance

The spending variance is the difference between the actual factory overhead and the budgetallowance based on the actual capacity (hours) attained.

The spending variance is computed as follows:

Actual factory overhead P25,000Budget allowance based on actual hours worked:

Variable – 4,600 hours x P2 P9,200Fixed 15,000 24,200

Spending variance – unfavorable P800The 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 P24,200Budget allowance based on standard hours allowed 24,600Variable 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 4,600Standard hours allowed 4,800Difference ( 200)Variable overhead rate P2Variable efficiency variance (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 P800

Variable efficiency variance-favorable (400)Volume variance-unfavorable 600Total overhead variance-unfavorable P1000

Four-variance methodThe variances which are computed under this method are the following:

1) Spending variance2) Variable efficiency variance 3) Fixed efficiency variance4) Idle capacity variance

Under this method, the volume variance is further split into two variances: a fixed efficiencyvariance 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) P13,800Standard hours x standard fixed overhead rate (4,800 x P3) 14,400Fixed overhead efficiency variance-favorable (P 600)

Budget allowance based on actual hours P24,200Actual hours x standard overhead rate (4,600 x P5) 23,200Idle capacity variance – unfavorable 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 P800Variable efficiency variance – favorable (400)

Controllable variance P400Fixed efficiency variance – favorable (P600)Idle capacity variance 1,200

Volume variance 600Total overhead variance – unfavorable P1000

Variance computation with work in processIt 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 @ P20Factory overhead – P40 per hourThe production data for a certain month are as follows:Units in process, beginning, 100% complete for material, 40%

Complete for conversion costs 2,000Units started in process 10,000Units completed 9,000Units 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 9,000Add: work in process, end:

Materials – 3,000 x 100% 3,000Conversion costs – 2,000 x 40% 1,200

12,000 10,200Deduct work in process, beginning:

Materials – 2,000 x 100% 2,000Conversion 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 unitsStandard labor hours allowed – 9,000 x 2 hours 18,000 hours

All variances would be computed using the same procedures previously discussed.

Mix variancesMix 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 Standard mix Standard price Standard cost

Grade 1 3(60%) P6 P18Grade 2 2(40%) 4 8

5(100%) 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 @ P6Grade 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 P39,000Grade 2 – 3,500 units x P4 14,000

P53,000Actual standard quantities at standard mix at standard prices:

Grade 1 – 10,000 units x 60% x P6 P36,000Grade 2 – 10,000 units x 40% x P4 16,000 52,000

Material mix variance-unfavorable 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) P53,000Actual quantities at average materials cost (10,000 units x P5.20) 52,000Materials 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 @ P6.00Grade 2 – 5,400 units @ P4.50Actual output – 2,000 unitsThe total materials variance is computed as follows:Actual materials cost:

\ Grade 1 – 6,600 units x P6.00 P39,600Grade 2 – 5,400 units x P4.50 24,300

P63,900Standard material costs:

Grade 1 – 2,000 units x 3 x P6 P36,000Grade 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 P39,600Grade 2 – 5400 units @ P4.50 24,300

P63,900Actual quantities at standard prices:

Grade 1 – 6600 units x P6.00 P39,600Grade 2 – 5400 units x P4.00 21,600 (61,200)

Materials price variance – unfavorable P 2,700

Or Materials price variance = 5400 units x P0.50

= P 2,700Actual quantities x standard materials cost (12,000 x P5.20) P62,400Standard quantities x standard materials cost (10,000 x P5.20) 52,000Materials usage variance – unfavorable (2,000 units x P5.20) P10,400

Actual quantities at actual mix at standard prices:Grade 1 – 6600 units x P6.00 P39,600Grade 2 – 5400 units x P4.00 21,600

P61,200Actual quantities at standard mix at standard prices:

Grade 1 – 12,000 x 60% x P6.00 P43,200Grade 2 – 12,000 x 40% x P4.00 19,200 62,400

Materials mix variance – favorable (P1,200)

Labor mix varianceAssume 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 costClass A 3 hours (50%) P15 P15Class B 3 hours (50%) 3 9

6 P24Standard labor cost per hour = P24.00 / 6 hours

= P4.00During the current period, the following labor hours were worked to produce 2,000 units of

product:Class A – 5,000 hours @ P5.00Class 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 P25,000Class B – 7,000 hours x P3.00 21,000

P46,000Actual hours at standard mix at standard prices:

Class A – 12,000 hours x 50% x P5.00 P30,000Class B – 12,000 hours x 50% x P3.00 18,000 48,000

Labor mix variance – favorable (P2,000)

Labor rate, efficiency, and mix variancesAssume 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 @ P6.00Class B – 6,750 hours @ P4.00The total labor cost variance is computed below.Actual labor cost:

Class A – 5,750 hours @ P6.00 P34,500Class B – 6,750 hours @ P4.00 27,000

P61,500

Standard labor cost:Class A – 2,000 units x 3 hrs. x P5 P30,000Class B – 2,000 units x 3 hrs. x P3 18,000 48,000Total labor cost variance 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 P34,500Class B – 6,750 hours @ P4.00 27,000

P61,500Actual hours x standard rates:

Class A – 5,750 hours @ P5.00 P28,750Class 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) P50,000Standard hours x average labor rate (12,000 hours x P4.00) 48,000Labor efficiency variance – unfavorable P 2,000

Actual hours at standard rates:Class A – 5,750 hours x P5.00 P28,750Class B – 6,750 hours x P3.00 20,250

P49,000Actual hours at standard cost per hour (12,500 hours x P4.00) 50,000Labor mix variance – favorable (P 1,000)

Yield varianceYield 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 x 100 Quantity of raw materials

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 variancesAssume 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 varianceAssume the same facts in the preceding example. Additional data on labor costs are given below.

Standard hours – ½ hour per liter of material inputStandard labor rate – P8.00 per hourActual 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 = ½ hour x P8.00 per hour 80%

= P5.00 per literBased 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 ½ hour per liter 80%

= 15,000 hours

Budget allowance based on standard hours allowed for actual input (see above) P136,000Standard hours allowed for actual input x standard overhead rate

(12,000 kg. x 1/5 hr. per kg. x P60) 144,000Volume variance – favorable (P 8,000)

Standard hours allowed for actual input x standard overhead rate (see above) P144,000Standard hours allowed for actual input x standard overhead rate

(9,000 kg. / 80% x 1/5 hr. per kg. x P60) 135,000Overhead yield variance - unfavorable P 9,000

QUESTIONS:1. Define standard costs2. State and distinguish the three types or levels of standards3. Enumerate some uses of standard costs4. State the advantages of using a standard cost system in accounting for the cost of products5. Are standard costs generally accepted for financial reporting purposes6. What are the two components of a standard cost7. How are standard overhead costs established?8. State and differentiate the different concepts of capacity9. State the various measures in which capacity may be expressed10. 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 variance15. 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 purchaseii. 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 materialb. Calculate the standard materials cost per unit of productc. 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 P360,000Normal capacity 80,000 hoursActual fixed overhead P354,000Standard hours allowed 64,000 hoursActual hours worked 70,000 hoursActual 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 P24,000Unfavorable variable efficiency variance 20,000Favorable spending variance 12,000

Required: Determine the following:a) The standard hours allowed b) The actual hours workedc) The applied overheadd) The actual overhead

12) The standard cost to produce a unit of product is as follows:Direct materials – 4 units @ P3.00Direct labor – 4 hours @ P4.00Factory overhead:

Variable – P5 per hourFixed – P3.00 per hour

Standard capacity – 4,000 hoursActual data for November

Actual output – 2,400 unitsActual materials purchased – 12,000 units @ P2.90Actual materials used – 9,800 unitsActual direct labor – 4,600 hours @ P4.20Actual factory overhead – P35,000

Required: a) Compute the variances related to materialsb) Compute the variances related to direct laborc) 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 P280Direct labor – 4 hours @ P25 per hour 100Factory overhead:

Fixed – 4 hours @ P12 48

Variable – 4 hours @ P8 32Total P460

Actual data for the month of October:Materials used – 1,440 yards P36Direct labor – 800 hours @P28Actual factory overhead – P18,000Completed production – 160 dressesEnding inventory - -32 dresses, fully complete for material and one-half

Complete for conversion costsRequired:

Determine the following variances from standard costs:a) Materials price variance (based on usage)b) Materials quantity variancec) Labor rate varianced) Labor efficiency variancee) Spending variancef) Variable efficiency varianceg) 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. @ P2Material B – 6 kgs. @ P3During the period , 100 units were produced at the following actual mix and costs:Material A – 600 kgs. @ P3.00Material B – 500 kgs. @ P2.50

Determine: a) The materials price varianceb) The materials usage variancec) The material mix variance

15) The standard labor cost to produce a product is made up as follows:Class A – 3 hours @P20.00Class B – 2 hours @P25.00During a period, 100 units were produced at the following actual hours and rates:Class A – 400 hours @ P20.00Class B – 200 hours @ P24.00

Determine:a) The labor rate varianceb) The labor efficiency variancec) 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 hourFixed – 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. @ P50Labor – 200,000 hours @ P20Overhead – P300,000

Determine:a) The material yield varianceb) The labor yield variancec) 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 P6,000Material 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 @ P1.95Material Y - 5,500 liters @ P4.05

Determine:a) The materials price varianceb) The materials mix variancec) 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 Usagea) P4,500 unfavorable P10,000 favorableb) P5,000 favorable P10,500 unfavorablec) P5,000 unfavorable P10,500 favorable

d) P10,000 favorable P 4,500 unfavorable

19) Information on Carino Company’s direct material costs for the month of January, 19A follows:

Actual quantity purchased 18,000Actual unit purchase price P3.60Materials purchase price variance –

Unfavorable (based on purchases) P3,600Standard quantity allowed for actual production 16,000Actual quantity used 15,000

For January, 19A there was a favorable direct material usage variance ofa) P3,360b) P3,375c) P3,400d) P3,800

20) The following processing standards have been set for Domeco Co.’s clerical workers

Number of hours per 1,000 papers processed 150Normal number of papers processed per year 1,500,000

Wage rate per 1, 000 papers P600Standard variable cost of processing 1, 5000, 000 papers P900, 000Fixed costs per year P150, 000

The following information pertains to the 1, 200, 000 papers that were processed during 19A:

Total cost P915, 000Labor cost P760, 000Labor hours 190, 000

1. For 19A, Domeco’s expected total cost to process the 1, 200, 000 papers, assuming standard performance, should bea. P910, 000b. P900, 000c. P870, 000d. P840, 000

2. For 19A, Domeco’s labor rate variance would bea. P40, 000 unfavorableb. P32, 000 favourablec. P10, 000 unfavourabled. P0

AICPA

21. For the month of April, Tuella Co. records disclosed the following data relating to direct labor:

Actual cost P10, 000Rate variance 1, 000Efficiency variance 1, 500Standard cost P9, 500

For the month of April, actual direct labor hours amounted to 2, 900. In April, Tualla’s standard direct labor rate per hour was

a. P5.50b. P5.00c. P4.75d. 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 P8.40 per hourStandard rate P8.00 per hourStandard hours allowed for

Actual production 2, 000 hoursLabor efficiency variance P1, 600 unfavourable

What were the actual hours worked?a. 1, 800b. 1, 810c. 2, 190d. 2, 200

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 ratePer direct labor hour P1.00

Standard variable overhead ratePer direct labor hour P4.00

Actual direct labor hours worked 39, 500Standard direct labor hours allowed

For actual production 39, 000Overall overhead variance-favorable P2, 000

The applied factory overhead for August, 19A should bea. P195, 000b. P197, 000c. P197, 500d. 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, 500Direct labor hours worked 19, 500Actual total overhead incurred P79, 500

What amount should Giron credit to the applied factory overhead account for the month of April, 19A?

a. P76, 000b. P78, 000c. P79, 500d. P80, 000

AICPA

25. Farol Company uses a flexible budget system and prepared the following information for 19B:

Normal MaximumCapacity Capacity

Percent of capacity 80% 100%Direct labor hours 32, 000 40, 000Variable factory overhead P64, 000 P80, 000Fixed factory overhead P160, 000 P160, 000Total factor overhead

Rate per direct labor hour P7 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 unfavourableb. P20, 000 unfavourablec. P18, 000 unfavourabled. 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 unitFixed 8 per unit

The following information pertains to the month of March, 19A:Units actually produced 38, 000Actual direct labor hours worked 80, 000Actual overhead incurred:

Variable P250, 000Fixed 384, 000

1. For March, 19A, the unfavourable variable overhead spending variance was

a. P6, 000b. P10, 000c. P12, 000d. P22, 000

2. For March, 19A, the fixed overhead volume variance wasa. 96, 000 unfavourableb. P96, 000 favourablec. P80, 000 unfavourabled. P80, 000 favourable

AICPAPROBLEMS

7.1 The Alvarez Co. manufactures a product which has the following standard materials and labor costs:

Materials – 100 pieces @ P.50 per pieceDirect 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 P20, 000Variable overhead 30, 000

During the month of October, the company produced 2, 200 units at the following actual costs:

Direct materials – 205, 000 pieces @ P.45Direct labor – 4, 300 hours @ P24.50Factory overhead:

Variable – P25, 000Fixed – 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. P20.00Direct labor – 8 hrs. @ P15.00 per hr. 120.00Factory overhead:

Fixed – 30% of direct labor P36.00Variable – 50% of direct labor 60.00 96.00

Total 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. @ P2.10Direct 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 metersRequisitioned – 336, 000 meters

Direct labor:Actual hours worked – 18, 000 hours @ P18.00

- 6, 000 hours @ P18.75Actual factory overhead:

Variable – P132, 000Fixed – 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 metersDirect 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% 90% 100% 120%Direct labor hours 16, 000 18, 000 20, 000 24, 000

Variable overhead P80, 000 P90, 000 P100, 000 P120, 000Fixed overhead 140, 000 140, 000 140, 000 140, 000Total overhead P220, 000 P230. 000 P240, 000 P260, 000

Required: Determine the following:a. Materials price varianceb. Materials quantity variancec. Labor rate varianced. Spending variancee. Variable efficiency variancef. 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. @ P3.00Direct 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 hourVariable – 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. @ P3.20Direct labor – 40, 500 hours @ P23.50Factory 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 two-

variance 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 P2.75Labor – 2 hrs. @ P20.00Factory overhead:

Fixed – P5.00 per hourVariable – 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 materialsand conversion costs 4,000 units

Started in process 9,000 unitsIn process, March 31, one-third complete with respect to

materials and conversion costs 3,000 unitsMaterials purchases – 110,000 kgs. 2 P2.80Materials usage – 94,000 kgs.Direct labor – 18,500 hours @ P19.50Factory 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. @ P5.00Labor – ½ hour @ P30.00Factory overhead:

Fixed – ½ hour @ P20.00Variable – ½ 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 20,000Completed and transferred 40,000In process, Feb. 28, 60% complete for conversion costs 10,000

Costs recorded:Materials purchased – 105,000 kgs. @ P5.15Materials issued – 89,000 kgs.Labor – 19,400 hours @ P30.40Factory 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 P10Direct labor – 3 hrs. @ P8.00 per hr. 24Factor overhead:

Fixed – 3 hrs. @ P4.00 per hr. P12Variable – 3 hrs. @ P2.00 per hr. 6 18

Total P52-----

The following miscellaneous data are available for the month of September:

Favorable materials price variance P 15,000

Unfavorable materials quantity variance 10,000Unfavorable labor rate variance 2,400Labor efficiency variance None

Unfavorable spending variance 12,000

Unfavorable volume variance 24,000Actual quantity purchased at standard price 100,000Actual quantity used at standard price 90,000

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

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

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

Factory overhead:Fixed – 2 hours @ P4.00Variable – 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) P3, 000 unfavorableMaterials quantity variance 5, 000 favorableLabor rate variance 3, 600 unfavorableLabor efficiency variance 2, 400 unfavorableControllable variance 1, 000 favorableVolume variance 4, 000 unfavorable

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

7.9 The standard materials and labor costs to produce a unit of product are as follows:

Materials:Material A – 4 kgs. @ P3.30Material B – 4 kgs. @ P2.00

Direct labor:Class A – 3 hours @ P6.00Class B – 5 hours @ P4.00

During July, 600 units were produced at the following materials and labor costs:Materials:

Material A – 2,750 kgs. @ P3.30Material B – 2,250 kgs. @ P1.80

Direct labor:Class A – 2,300 hours @ P6.00Class 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 Kilogram Cost per kilogram Total_

Grade 1 30 P1.40 P 42.00Grade 2 18 2.00 36.00Grade 3 12 3.50 42.00

60 P120.00 --- ----------

During a certain month, 360,000 kilograms were used in the following proportions and costs:

Grade 1 – 144,000 @ P1.50Grade 2 – 126,000 @ P2.20Grade 3 - 90,000 @ P 3.40

The actual production of finished goods during the year was 5,800 units.

Required: Determine the materials price, mix, and yield variances.

7.11 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 literDirect 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 @ P23.00Direct 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 P57.60Material B – 4.2 kg. @ P 5.00 21.00Material C – 3.0 kg. @ P 8.00 _ 24.00

12.0 kg. 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 unitsMaterials purchased:

Material A – 24,000 kgs. @ P11.25Material B – 20,500 kgs. @ P 5.60Material 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 @ P24.75Factory overhead:

Fixed – P62,000Variable – 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 P27Direct labor – 4 hours @ P9.00 per hour 36Factory overhead – applied at five-sixths of direct labor.

Ratio variable costs to fixed costs: 2 to 1 30Total standard cost per unit of output 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 P24,840Direct materials used – 9,500 yardsDirect labor – 2,100 hours @ P9.15 per hour 19,215Actual factory overhead 16,650

500 units of the product were actually produced in July, 19A.

Required:a. Prepare the following schedules computing:

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 variance3. Labor rate variance4. Labor efficiency variance5. Controllable factory overhead variance6. Capacity (volume) factory overhead variance.

AICPA

7.14 At the beginning of 19A, Belarmic Company adopted the following standards:

Direct materials 3 lbs. @ P2.50 per lb. P7.50Direct labor 3 hrs. @ 7.50 per hr. 37.50Factory overhead:

Variable P3.00 per direct labor hour 15.00Fixed P4.00 per direct labor hour 20.00

Standard cost per unit -------

Normal volume per month is 40, 000 standard labor hours. Belarmino’s January, Belarmino produced 7, 800 units, with records indicating the following:

Direct materials purchased 25, 000 lbs.@ P2.60

Direct materials used 23, 000Direct labor 40, 100 hrs. @ P7.30Factory overhead 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 variance4. Direct labor efficiency variance.5. Factory overhead spending variance.6. Variable factory overhead efficiency variance7. 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 hrOverhead 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 1 200(25% complete) 825

Returns started in MarchReturns in process, March 31

(80% complete) 125

Actual cost data

Returns in process, March 1 P6, 000Labor 2, 500Overhead

Labor, March 1 to 314, 000 hours 89, 000

Overhead, March 1 to 31 45, 000

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) Total labor(2) Labor rate(3) Labor efficiency(4) Total overhead(5) Overhead volume(6) Overhead budget

AICPA

CHAPTER 8Republic 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 Processed Completed SoldRaw materialsDirect labor Work in process Finished goods Cost ofFactory overhead 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, are reproduced below to illustrate the accounting procedures under a standard cost system:

Standard costs:Direct material – 10 units @ P.90 P9.00Direct labor – 2 hours @ P7.50 15.00

Factory overhead:Variable – 2 hours @ P2.00 P4.00Fixed – 2 hours @ P3.00 6.00 10.00

Total standard cost P34.00---------

Actual operating data for current month:Materials purchased – 30, 000 units @ P1.00Materials used – 22, 000 unitsLabor hours worked – 4, 600 hours @ P7.75Actual overhead incurred: Variable – P10, 000

Fixed – P15, 000Completed 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) P27, 000Materials price variance (30, 000 x P.10) 3, 000

Accounts payable (30, 000 x P1.00) P30, 000

Method II (materials recorded at actual):

Materials (30, 000 x P1.00) P30, 000Accounts 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, 600Materials quantity variance (2, 000 x P.90) P1, 800Materials (22, 000 x P.90) 19, 800

Method II

Work in process (24, 000 x P.90) P21, 600Materials per usage variance (22, 000 x .10) 2, 200

Materials quantity variance (2, 000 x P.90) P1, 800Materials 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, and2) Entry to distribute the payroll.

The entries are:Payroll P35, 650

Accrued payroll (no payroll deductions Assumed) P35, 650

Work in process (4, 800 x P7.50) P36, 000Labor rate variance (4, 600 x P.25) 1, 150

Labor efficiency variance (200 x P7.50) P1, 500Payroll 35, 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 P25, 000

Various credits P25, 000

Recording application of overhead costs

The entry to apply overhead to the products 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 P400Volume variance 600

Factory overhead control P1, 000Three-variance method:

Spending variance P800Volume variance 600

Variable efficiency variance P400Factory overhead control 1, 000

Four-variance method:Spending variance P800Idle capacity variance 1, 200

Variable efficiency variance P400Fixed efficiency variance 600Factory overhead control 1, 000

Recording transfer of completed unitsThe following entry is made to record the transfer of finished products:

Finished goods (2, 400 x P34) P81, 600Work 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 unitsWhen 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, 000Sales P144, 000

Cost of goods sold (at standard) P81, 600Finished goods P81, 600

Recording mix and yield variancesThe following entries for mix and yield variances are based on the last example of the preceding

chapter:Materials variances:

Materials P127, 000Materials purchase price variance P17, 700Accounts payable 109, 500

To record purchase of materials.

Work in process P124, 800Materials mix variance 2, 400Materials P127, 200To record issuance of materials.

Finished goods P117, 000Materials yield variance 7, 800

Work in process P124, 800To record transfer of materials to

finished goods.Labor Variances:

Payroll P 63, 000Accrued payroll P 63, 000

Work in process P 96, 000Labor rate variance P 9, 000Labor efficiency variance 24, 000Payroll 63, 000

To record distribution of payroll,

Finished goods P 90, 000Labor yield variance 6, 000

Work in process P 96, 000To record actual overhead costs incurred.

Overhead variances:Factory overhead control P140, 000

Various credits P140, 000To record actual overhead costs incurred.

Work in process P144, 000Factory overhead control P144, 000

To record overhead applied to products.Factory overhead control P 4, 000Controllable variance 4, 000

Volume variance P 8, 000To close factory overhead control and

set up variances (two-variance method).Finished goods P135, 000Overhead yield variance 9, 000

Work in process P144, 000To record transfer of overhead to

finished goods.

Disposition of variancesAt 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 Sold2) Variances may be closed to the Income Summary3) 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 IIStandard 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 SoldRaw materialsDirect labor work in process Finished goods Cost of goods soldFactory 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 P9.00 Direct labor - 2 hours @7.50 15.00 Factory overhead: Variable – 2 hours @ P2.00 P4.00 Fixed-2 hours @ P3.00 6.00 10.00 Total standard cost P34.00Actual operating data for current month:

Materials purchased – 30,000 units @ P1.00Material used - 22,000 unitsLabor hours worked - 4,600 hours @ P7.75Actual overhead incurred: Variable – p10,000

Fixed - P15,000Completed production - 2,400 units

Recording purchase of materialsThere 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) P27,000Materials price variance (30,000 x P.10) 3,000 Accounts payable (30,000 x P1.00) 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) 22,000Under 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) P36,000Labor rate variance(4,600 x P.25) 1,150 Labor efficiency variance(200 x P7.50) P1,500 Payroll 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 600 Factory overhead control P1,000

Three-variance method:Spending variance P800Volume variance 600 Variable efficiency variance P400 Fixed efficiency variance 600

Four-variance method:Spending variance P800Idle capacity variance 1,200 Variable efficiency variance P400 Fixed efficiency variance 600 Factory overhead control 1,000

Recording transfer of completed unitsThe following entry is made of record the transfer of finished products:Finished goods(2,400 x P34) P81,600 Work in process P81,600The 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 unitsWhen 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) P144,000sales P144,000

cost of goods sold(at standard) P81,600finished goods P81,600

Recording mix and yield variancesThe following entries for mix and yield variances are based on the last

example of the preceding chapter:Materials P127,200

Materials purchase price variances P17,700Accounts payable 109,500

To record purchase of materials.Work in process P124,800Materials mix variance 2,400

Materials P127,200 To record issuance materials.

Finished goods P117,000Materials yield variance 7,800

Work in process P124,800 To record transfer of materials to finished goods.

Labor variances:Payroll P63,000 Accrued payroll. P63,000

To record payroll.Work in process P96,000

Labor rate variance 24,000Labor efficiency variance 9,000Payroll 63,000

To record distribution of payroll.Finished goods P90,000Labor 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 P144,000Factory overhead control P144,000 To record overhead applied to products.

Factory overhead control P4,000Controllable variance 4,000

Volume variance P8,000 To close factory overhead control and setup variances (two-

variance method).Finished goods P135,000Overhead yield variance 9,000

Work in process P144,000 To record transfer of overhead to finished goods.

Disposition of variancesAt 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 accounting year, the deferred variances may be disposed of in any of the three ways cited above.

Variances closed to cost of goods soldWhen 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 P 1,850Materials quantity variance 1,800Materials efficiency variance 1,500

Materials price variance P3,000Labor rate variance 1,150Controllable variance 400Volume variance 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 statementSales P144,000Cost of goods sold, at standard P81,600Add favorable variances:

Material price variance P3,000 Labor rate variance 1,150Controllable variance 400Volume variance 600 5,150

P 86,750Deduct favorable variances:

Materials quantity variance P1,800Labor efficiency variance 1,500 3,300

Cost of goods sold, at actual 83,450Gross profit P60,550Selling and administrative expenses 30,000Net income P30,550

Variances closed to income summaryVariances 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 P1,850Materials quantity variance 1,800Labor efficiency variance 1,500

Materials price variance P3,000Labor rate variance 1,150Controllable variance 400Volume variance 600

The variances may be presented in the income statement in the following manner:

Income StatementSales P144,000Cost of goods sold, at standard 81,600Gross profit P62,400Less selling and administrative 30,000Net income, at standard P32,400Add favorable variances:

Materials quantity variance P1,800Labor efficiency variance 1,500 3,300

P35, 700Deduct unfavorable variances:

Materials price variance P3,000Labors rate variance 1,150Controllable variance 400Volume variance 600 5,150

Net income, at actual P30,550Allocation 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 P30,000Labor efficiency variance 20,000Overhead 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 %

TotalMaterials P100,000 25 P100,000Work in process 40,000 10 P17,500 10 P12,500 10

70,000Finished goods 80,000 20 61,250 35 52,500 42 193,750Cost of sales 180,000 45 96,250 55 60,000 48

336,250P400,000 100 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 P30,000Labor efficiency variance 2,000 7,000 11,000 20,000Overhead volume variance 1,500 6,300 7,200 15,000 P7,500 P6,500 P19,300 P31,700 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 soldStandard cost before allocation P100,000 P70,000 P193,750 P336,250Allocation of variances 7,500 6,500 19,300 31,700Actual costs P107,500 P76,500 P213,050 P367,950

Variance analysisVariance 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 department3. Higher delivery costs4. Emergency purchase of materials5. 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 handling2. Poor machinery3. Inexperienced workers 4. Pilferage5. Excessive spoilage6. Changes in production specifications or quality control procedures7. 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 variancesLabor rate variances may be due to the following causes:

1. Labor rate or wage increase2. Substitution of higher paid labor for lower paid labor3. Use of an average rate for several types of labor

Labor efficiency variances may be attributable to the following:1. Substandard materials2. Production bottlenecks or stoppages 3. Changes in machinery, layout, or quality control standards 4. Faulty equipment5. Lack of proper equipment maintenance6. Poor supervision7. Faulty instructions8. Changes in efficiency of employees due to personal, family, or financial

problemsThe 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 supplies2. Change in wage rates, power rates, tax rates, depreciation rates, premium

rates, etc.3. Acquisition or disposal of plant assets4. Changes in depreciation methods5. 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 conditions2. Poor sales demand3. Strikes4. Shortage of material5. Weather6. Inadequate or poor marketing practices7. Poor quality of products8. 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 variancesControl 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, and2. 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 information3. 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 Actual

variable

unfavorable(Favorable)Materials P18,000 P 18,600

P600Direct labor 12,300 12,500

200

Supplies 4,000 4,500 500

Indirect labor 5,600 5,700 100Depreciation 3,000 3,000

0Repairs and maintenance 4,400 4,200

(200)Power 2,700 2,400 (300)Insurance 1,800 1,800 0Taxes 3,400 3,500

100 P55,200 P56,200

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. @ P16.00P48.00Material B – 5 sq. ft. @ P24.00

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. @ P17.00Material 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 P140,000Controllable variance 10,000

(debit)Volume variance 5,000 (credit)

Required: Determine the following:a) Factory overhead appliedb) Total overhead rate per hourc) 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:

Debit CreditMaterials price variance P6,400

Materials quantity varianceP4,500

Labor rate variance 3,600Labor efficiency variance 2,200Overhead 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 Orlando’s accounting records are as follows:Sales P1,200,000Cost of goods sold 720,000Inventories:

Direct materials 36,000Work in process 54,000Finished goods 90,000

Under Orlando’s 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. P682,000b. P684,000c. P756,000d. P757,500

PROBLEMS8.1 The Estella Co. produces a single product having the following

standard costs:Materials – 1 cu. ft. @ P50.00 P50.00Direct labor – ½ hour @ P24.00 12.00

Factory overhead:Fixed – ½ hour @ P6.00 3.00Variable – ½ hour @ P10.00 5.00Total standard cost per unit P70.00

Normal capacity 5,000 units

Actual data for FebruaryProduction 4,500 unitsMaterials purchased 4,800 cu. ft. @

P49.00Materials used 4,600 cu. ft.Direct labor 2,300 hours @ P24.50Factory overhead P35,000Sales 4,200 units @ P120.00

Required: Prepare all journal entries to record the above transactions using a two-variance method for overhead.

8.2 A standard cost sheet for one of the products of the Arsenio Company shows the following:

Direct materials – 12 units @ P4 P48Direct labor – ½ hour @ P40 20Factory overhead (based on direct labor hours):

Fixed 9Variable 6

Standard cost per unit P83

The following transactions occurred during March:1) Manufactured 7,600 units of product.2) Purchased 94,000 units of raw materials at a total cost of

P357,200.3) Issued 89,000 units of raw materials for use in production.4) Paid P163,800 for 3,900 hours worked during the month

(assume no payroll deductions).5) Actual factory overhead recorded was P126,0006) 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

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 P12Direct labor – 2 hours @ P10.00 per hour 20Factory overhead – 2 hours @ P5.00 10Total 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 10,000Completed 9,000In process, Sept. 30, all materials ½ converted

1,000Cost recorded:

Direct materials used – 62,000 units P136,400

Direct labor – 18,500 hours 194,250

Factory overhead 98,000Actual 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. @ P0.50Material B – 40 kg. @ P0.30Material C – 30 kg. @ P0.60

During April, the following materials quantities were purchased:Material A – 290,000 kg. @ P0.45Material B – 310,000 kg. @ P0.35Material 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 @ P5.00Direct labor – 2 hours @ P18.00Factory overhead:

Variable – P4.00 per hourFixed – 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 CreditMaterials price variance

P3,000Materials usage variance P2,500Labor rate variance 7,100Labor efficiency variance 3,600Overhead controllable variance 2,000Overhead volume variance 6,000Required: 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

8.6 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 P24Direct labor – ½ hour @ P30 15Factory overhead:

Fixed – ½ hour @ P10 5Variable – ½ 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 unitsUnits sold – 4,000 unitsRaw materials – 38,000 units

The following variances were recorded for the same month:Materials price varianceP7,600 ( 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 NoneThe 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 P5.00Direct labor – 1 hour @ P9.00 9.00Factory overhead:

Fixed – 1 hour @ P4.00 4.00Variable – 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 @ P0.95Direct labor – 49,600 hours @ P9.20Factory overhead:

Fixed – P200,000Variable – P94,000

Selling expenses – P135,000Administrative 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 P30.00Labor – 3 hours @ P12.00 36.00

The factory overhead at a standard capacity of 9,000 hours per month has been budgeted as follows:

Fixed – P54,000Variable – P45,000

Operating data for the year ended December 31, 19C are summarized as follows:

Production – 3,200 unitsSales – 2,800 units @ P120.00 per unitMaterials purchased – 50,000 units @ P2.05Materials issued – 47,500 unitsLabor – 9,500 hours @ P11.75Factory overhead – P112,000Selling 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.