sm_ch04

CHAPTER 4

QUESTIONS

1. The objective of financial reporting is to provide useful information for users of the financial statements. The relevant informa-tion for decision making is future data, es-pecially information dealing with cash flows. The primary financial statements reflect economic transactions and events that have taken place. The past is used to help project the future. Income, however, is only one of many sources of cash flow. The bal-ance sheet and statement of cash flows also furnish relevant information upon which the investor may project other future cash flows. In summary, the income state-ment contains only some of the information that is relevant for making economic deci-sions.

2. Two approaches can be used to measure income: the capital maintenance approach and the transaction approach. The capital maintenance approach uses the balance sheet elements to determine the change in total equity after eliminating any invest-ments and withdrawals of resources by owners. The transaction approach deter-mines income by analyzing individual trans-actions and events and their effect on re-lated assets, liabilities, and owners’ equity. Although the method of determining income differs, both approaches arrive at the same total income figure if the same attributes and measurements are used. However, the transaction approach produces more detail as to the composition of income than does the capital maintenance approach.

3. Measurement methods that could be ap-plied to net assets in the capital mainte-nance approach to income determination are as follows:(a) The historical cost of net assets ac-

quired in exchange transactions, re-duced by an allowance for their use.

(b) The historical cost of net assets ac-quired in exchange transactions, re-duced by an allowance for their use and adjusted for a change in price lev-els since original acquisition.

(c) The current value of net assets ac-quired in exchange transactions as de-termined by either their replacement or market values.

(d) Some variation of the above (a through c) but including in assets all resources and claims to resources, not just those acquired in exchange transactions.

4. The objectives of reporting income for income tax purposes and for financial re-porting to users are not the same. Those formulating income tax laws are usually concerned with fairness among taxpayers and with their ability to pay taxes. Users, on the other hand, are concerned with a mea-sure that distinguishes between a return on investment and a return of investment. They want a measure that matches ex-penses against recognized revenue. In most cases, the same accounting method can be used for both purposes. This will re-duce both the cost and the confusion of us-ing more than one accounting method for the same transaction. In some cases, how-ever, the generally accepted accounting method is different from that required by in-come tax regulations. This results in a tem-porary difference between the tax return and the books and gives rise to interperiod income tax allocation.

5. A code law country is one in which rules, laws, and accounting standards are set by legal processes—from the top down. A common law country is one in which rules, laws, and accounting standards evolve in response to societal and market forces—from the bottom up.

6. Revenues and expenses are related to the ongoing major or central activities of a busi-ness and are reported at gross amounts. Gains and losses are associated with pe-ripheral and incidental transactions and events and are reported as the difference between the selling price and the book value (often the depreciated cost). These classification and display distinctions will depend on the specific circumstances and activities of an enterprise.

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7. The following two factors must be consid-ered when deciding at what point revenues and gains should be recognized: (a) The resources from the transaction are either already realized in cash or claims to cash or are readily realizable in cash, and (b) the revenues and gains have been earned through substantial completion of clearly identified tasks and activities. Both factors are usually met when merchandise is deliv-ered or services are rendered to cus-tomers. This is referred to as the point of sale.

8. There are three specific exceptions to the general rule that were discussed in the chapter. They are recognizing revenue (a) at the point of completed production, (b) at the time of cash collection, and (c) at various points in time during the operating cycle (e.g., percentage-of-completion method). The justification for the use of these exceptions is that, in each case, the realization and earning criteria established by the FASB are met.

9. Three expense recognition principles are applied in matching costs with revenues:

(a) Direct matching—costs are associated directly with specific revenues and rec-ognized as expenses of the period in which the revenues are recognized.

(b) Systematic and rational allocation—when costs cannot be associated di-rectly with specific revenues, costs are associated in a systematic and rational manner with the periods or products benefited.

(c) Immediate recognition—those costs that cannot be related to revenues ei-ther by direct matching or by system-atic and rational allocation must be rec-ognized as expenses of the current period.

10. The multiple-step income statement can contain too much information that might be confusing to the reader and require excess time to evaluate. The detailed listing of pur-chases and inventory might best be dis-played in a supplementary schedule.

The single-step income statement can be too brief. Information required for invest-ment decisions is sometimes presented in supporting schedules or not reported. Be-cause of these factors, the statement could also be confusing, and valuable time could

be lost by the statement reader in seeking additional information.

11. The major sections that may be included in a multiple-step income statement may be divided into two categories: (a) income from continuing operations, separated into six sections, and (b) irregular or extraordinary items, separated into three sections. The sections of income from continuing opera-tions are

1. Revenue from net sales2. Cost of goods sold3. Operating expenses4. Other revenues and gains5. Other expenses and losses6. Income taxes on continuing operations

The sections of irregular or extraordinary items are

7. Discontinued operations8. Extraordinary items9. Cumulative effects of changes in ac-

counting principles

12. A restructuring charge is a loss that arises when a company proposes a restructuring of its operations. The charge is composed of the loss in value associated with assets that no longer fit in the company’s strategic plans. The charge also includes the addi-tional costs associated with the termination or relocation of employees. Restructuring charges are controversial because compa-nies exercise considerable discretion in de-termining the amount of a restructuring charge and thus can use restructuring charges as a tool for manipulating the amount of reported net income.

13. This flexibility in the timing of the recogni-tion of restructuring charges is reduced by SFAS No. 146. Intraperiod income tax allo-cation involves the separation of income tax expense between income from continu-ing operations and transitory, irregular, or extraordinary items. Under this concept, each section of the transitory, irregular, or extraordinary items category is reported net of its income tax effect.

14. Pop-Up must separately disclose the cur-rent year’s income related to the operations of the segment that will be discontinued to-gether with the $10,000 loss resulting from the sale. This total would be reported on the income statement, along with any asso-

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ciated income tax impact, immediately fol-lowing income from continuing operations.

15. The following items would not normally qualify as extraordinary items:

(a) The write-down or write-off of receiv-ables.

(b) Major devaluation of foreign currency.(c) Loss on sale of plant and equipment.(d) Gain from early extinguishment of debt.

Before the issuance of SFAS No. 145 in April 2002, gains and losses from early extinguishment of debt were re-quired to be classified as extraordinary.

(f) Loss due to extensive earthquake dam-age to furniture company in Los Ange-les, California. (Earthquakes are not unusual in the Los Angeles area.)

(g) Farming loss due to heavy spring rains in the Northwest. (Spring rains are not unusual in the Northwest.)

Item (e) is classified as extraordinary because flood damage is both unusual and infrequent in Las Vegas.

16. a. The effects of a change in accounting principle that is applied to past periods are disclosed in the financial state-ments of the period of change. The ef-fects of the change are computed for past periods and disclosed either as a cumulative effect on current net income or as an adjustment to the beginning retained earnings. The FASB has spec-ified criteria to determine which ap-proach is appropriate.

b. The effect of a change in accounting estimate is disclosed entirely in the cur-rent period or in the current and future periods. No adjustments are made to prior periods’ statements as may be done for a change in principle. The change in an estimate should be suffi-ciently disclosed in the financial state-ments so that readers are alerted to those changes that will materially affect future periods.

17. Under International Financial Reporting Standard (IFRS) 8, the cumulative effect of

18. a change in accounting principle is re-ported as a direct adjustment to begin-ning retained earnings of the current year.

18. Generally accepted accounting principles require entities to report earnings-per-share information for income from continuing op-erations and for each section of the transi-tory, irregular, or extraordinary items cate-gory of an income statement. The compu-tation is made by dividing the income or loss from each of these sections by the weighted average number of common shares outstanding during the reporting period. If a potential dilution of earnings exists due to the existence of convertible securities, stock options, or stock warrants, additional earnings-per-share information must also be presented.

19. “Comprehensive income is the change in equity of a business enterprise during a pe-riod from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a pe-riod except those resulting from invest-ments by owners and distributions to own-ers.”1 Net income is the reported income as required by GAAP. Currently, GAAP does not require all components of comprehen-sive income to be disclosed in the income statement. For example, it does not include the effect of error corrections, asset valua-tion changes, or some effects of accounting changes.

20. The starting point for the preparation of forecasted financial statements is the fore-cast of sales.

21. In forecasting depreciation expense, one first must forecast how much property, plant, and equipment will be needed in the future. This amount is then used, along with an assumption about how rapidly the plant and equipment will depreciate, to esti-mate future depreciation expense.

1Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford, CT: Finan-

cial Accounting Standards Board, December 1985), par. 70.

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PRACTICE EXERCISES

PRACTICE 41 FINANCIAL CAPITAL MAINTENANCE

Net assets, end of period $345,000Net assets, beginning of period 170,000 Increase in net assets $175,000Deduct investment by owners 100,000

Income $ 75,000

PRACTICE 42 PHYSICAL CAPITAL MAINTENANCE

Net assets, end of period $345,000Net assets, beginning of period 170,000 Increase in net assets $175,000Deduct investment by owners 100,000 Income, financial capital maintenance $ 75,000Deduct increase necessary to maintain physical capital 65,000

Income, physical capital maintenance $ 10,000

PRACTICE 43 COMPUTATION OF INCOME USING MATCHING

Revenue ($150,000 + $91,000) $241,000Cost of goods sold ($79,000 + $46,000) 125,000

Income $116,000

The $350,000 in costs incurred in the production of Machines B and D will not yet be recog-nized as an expense. This expense is matched and reported in the income statement in the same year in which the revenue from the sale of the machines is reported. In the mean-time, this $350,000 cost is shown as an asset, Inventory, in the balance sheet.

PRACTICE 44 REVENUE RECOGNITION

Cash Collected Amount ofor Collectibility Work Revenue to Be

Reasonably Assured? Completed? Recognized

a. No Yes $ 0b. Yes No 0c. Yes Yes 170,000

Total revenue to be recognized this year $170,000

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PRACTICE 45 EXPENSE RECOGNITION

Expense ExpenseAmount of Recognition to Be Recognized

Cost Method This Yeara. $30,000 Direct matching $ 30,000b. 70,000 Immediate recognition 70,000c. 15,000 Rational allocation 5,000d. 27,000 Immediate recognition 27,000e. 45,000 Rational allocation 9,000f. 50,000 Direct matching 0Total expense recognized this year $141,000

PRACTICE 46 SINGLE-STEP INCOME STATEMENT

Sales $10,000

Less expenses:Cost of goods sold 6,000Selling and administrative expense 750Interest expense 1,100

Income before income taxes $ 2,150

Income tax expense 1,200Net income $ 950

PRACTICE 47 MULTIPLE-STEP INCOME STATEMENT

Sales $10,000Cost of goods sold 6,000Gross profit $4,000

Operating expenses:Selling and administrative expense 750

Operating income $3,250Interest expense 1,100 Income before income taxes $2,150Income tax expense 1,200

Net income $ 950

PRACTICE 48 COMPUTATION OF GROSS PROFIT

Revenues.............................................. $9,488.8

Cost of sales......................................... 5,784.9

Gross profit.................................... $3,703.9

Gross profit/Sales = $3,703.9/$9,488.8 = 39.0%

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PRACTICE 49 COMPUTATION OF OPERATING INCOME

Revenues........................................................... $9,488.8

Operating expenses:

Cost of sales................................................ 5,784.9

Selling and administrative............................ 2,689.7

Restructuring charge, net (Note 13).............. (0.1)

Total operating expenses.................................... $8,474.5

Operating income............................................... $1,014.3

Operating income/Sales = $1,014.3/$9,488.8 = 10.7%

PRACTICE 410 COMPUTATION OF INCOME FROM CONTINUING OPERATIONS

Sales $10,000Cost of goods sold 4,000Gross profit $ 6,000Less: Selling and administrative expense 1,750Operating income $ 4,250Interest expense 1,100Income before income taxes $ 3,150Income tax expense (40%) 1,260Income from continuing operations $ 1,890

PRACTICE 411 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS

2005 2004 Sales $ 5,000 $4,600Expenses 4,400 4,100Income before income taxes $ 600 $ 500Income tax expense (30%) 180 150Income from continuing operations $ 420 $ 350Discontinued operations:

Income (loss) from operations(including loss on disposalin 2005 of $2,000) $(2,400) $600

Income tax expense (benefit)30% (720) 180Income (loss) on discontinued operations (1,680) 420

Net income $(1,260) $ 770

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PRACTICE 412 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS

2005 2004 Sales $ 3,500 $5,100Expenses 3,900 4,500Income before income taxes $ (400) $ 600Income tax expense (benefit) 30% (120 ) 180Income from continuing operations $ (280) $ 420Discontinued operations:

Income from operations(including gain on disposalin 2005 of $1,500) 2,100 500Income tax expense30% 630 150Income on discontinued operations 1,470 350

Net income $ 1,190 $ 770

PRACTICE 413 GAINS AND LOSSES ON EXTRAORDINARY ITEMS

Sales $20,000Cost of goods sold 11,000Gross profit $ 9,000Operating expenses and gains/losses:Selling and administrative expense (1,750)Operating income $ 7,250Other revenues and expenses:

Loss from an unusual but frequent event$(1,000)Gain from a normal but infrequent event 1,250Interest expense (2,100) (1,850)

Income before income taxes $ 5,400Income tax expense (40%) 2,160Income from continuing operations $ 3,240Extraordinary loss (net of tax benefit of $160) (240)Net income $ 3,000

PRACTICE 414 CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

2005 2004 2003 Sales $5,000 $3,000 $2,000Oil and gas exploration expense 700 600 400Income before income taxes $4,300 $2,400 $1,600Income tax expense (30%) 1,290 720 480Income from continuing operations $3,010 $1,680 $1,120Cumulative effect of change

in accounting principle (net of incometax benefit of $510) (1,190) 0 0

Net income $1,820 $1,680 $1,120

Cumulative effect = [($400 + $600) – ($1,500 + $1,200)] = ($1,700)

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PRACTICE 415 ACCOUNTING FOR CHANGES IN ESTIMATES

Original depreciation = $100,000/20 years = $5,000 per yearAccumulated depreciation as of January 1, 2005 = $5,000 per year 5 years = $25,000

Revised depreciation = Remaining depreciable book value/Remaining life= ($100,000 $25,000)/(30 years 5 years elapsed already)= $75,000/25 years= $3,000 per year

PRACTICE 416 RETURN ON SALES

Return on sales = Net income/Sales = $200/$13,000 = 1.5%

PRACTICE 417 EARNINGS PER SHARE

2005 2004 2003 Net income $10,000 $6,000 $2,500Average shares outstanding 2,500 2,000 1,000

Earnings per share $4.00 $3.00 $2.50

Percentage increase in 2004: ($3.00 $2.50)/$2.50 = 20%Percentage increase in 2005: ($4.00 $3.00)/$3.00 = 33%

PRACTICE 418 PRICE-EARNINGS (P/E) RATIO

Price-earnings ratio = Market price per share/Earnings per share = $20.00/$1.67 = 12.0

PRACTICE 419 COMPREHENSIVE INCOME

Income from continuing operations $ 11,000Extraordinary loss (1,000)Cumulative effect of a change in accounting principle (400)

Net income $ 9,600

Net income $ 9,600Unrealized loss on available-for-sale securities (2,100)Foreign currency translation adjustment (equity increase) 1,250

Comprehensive income $ 8,750

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PRACTICE 420 FORECASTED BALANCE SHEET

2005 2006Actual Forecasted

Cash $ 100 $ 125 natural increase of 25%Accounts receivable 500 625 natural increase of 25%Inventory 1,000 1,250 natural increase of 25%Land 2,500 2,500 no increase neededPlant and equipment (net) 5,000 7,000 40% increase

Total assets $9,100 $11,500

PRACTICE 421 FORECASTED INCOME STATEMENT

2005 2006 Actual Forecasted

Sales $10,000 $13,000 30% increase (given)Cost of goods sold 6,000 7,800 30% natural increaseDepreciation expense 1,000 1,200 same proportion with PPEInterest expense 400 500 same apparent 10% interest rateIncome before income taxes$ 2,600 $ 3,500Income tax expense 910 1,225 same tax rate ($910/$2,600) = 35%

Net income $ 1,690 $ 2,275

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EXERCISES

4–22.

Debit changes in accounts during 2005 other than Retained Earnings:

Cash............................................................................ $ 95,500Accounts Receivable................................................ 92,000Buildings and Equipment (net)................................ 190,000Accounts Payable..................................................... 75,000 $452,500

Credit changes in accounts during 2005 other than Retained Earnings:

Inventory.................................................................... $ 30,000Patents........................................................................ 5,000Bonds Payable........................................................... 150,000Capital Stock.............................................................. 100,000Additional Paid-In Capital........................................ 50,000 335,000

Change in Retained Earnings for 2005........................ $117,500Add: Dividends declared............................................... 25,000 Net income....................................................................... $ 142,500

4–23.

(a) The receipt of an order from a customer does not constitute realization, nor does it qualify as an earnings activity. Therefore no revenue is rec-ognized.

(b) There has been no sale of the asset to support the recognition of rev-enue. Production remains to be performed, followed by sale of the fin-ished product. Accretion may give rise to revenue in certain instances in which it can be objectively determined and the product has a ready market at a definite price.

(c) The rendering of services is the earning activity, and it is assumed that a valid claim exists against the client. The recognition criteria are met.

(d) The appreciation in value of the land is generally not recognized be-cause it is not yet realized.

(e) The receipt of cash meets the realization criteria; however, the revenue is generally not reported as earned because the product has not yet been delivered. Some argue that an estimate of the costs incurred to honor the certificate can be made so that revenue could be recognized at the time of certificate sale.

(f) Collection of cash on the subscriptions is realization. However, the earning activity has yet to take place.

(g) The retirement of debt at less than the recorded liability results in the recognition of a gain. The retirement of the debt meets the recognition criterion for gains.

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4–24.

(a) The revenue is unearned in 2005. The credit is to the liability account Unearned Rent Revenue.

(b) Revenue of $60,000 is to be recognized in 2005: $10,000 in cash plus a note for $50,000. In addition, interest revenue of $3,000 is recognized in 2005 ($50,000 0.12 1/2 year). The $3,000 interest revenue to be earned in 2006 will not be recorded until 2006.

(c) Transactions in a company’s own stock are not considered an income-generating activity. The amount received above par is credited to Addi-tional Paid-In Capital.

(d) Because a claim against the customer (an asset) is created when the merchandise is shipped and actions to prepare and ship the inventory are felt to represent the earning activity, revenue is recognized at the time of sale. In theory, the possibility of return should be evaluated and recorded as a reduction of revenue if some return is probable and the value of the return can be estimated. Similarly, the probability of a cus-tomer’s taking a cash discount should be considered and a reduction made to revenue for estimated cash discounts. In practice, both sales returns and cash discounts are usually not recorded until they actually occur.

(e) This is a difficult one. As discussed in Chapter 8, under the provisions of SAB No. 101 the SEC generally does not allow the recognition of rev-enue until title transfers. In such a case, the receipt of the 15% down payment would be recorded as a debit to cash and a credit to a liability such as Deposit Liability.

(f) The initial agreement does not represent a claim against the client until the contract is at least partially complete. Because part of the work was accomplished in 2005, a portion of the revenue could be recognized in 2005 on a percentage basis. However, because the bulk of the work will be done in 2006, revenue could be deferred until the audit is completed and billed.

4–25.

(a) Immediate recognition. The future benefits of the new drug are highly uncertain.

(b) Direct matching. The warranty costs are anticipated expenses that are directly related to revenues.

(c) Systematic and rational allocation. The lease agreement benefits sev-eral accounting periods in a systematic and rational way.

(d) Direct matching. Labor associated with assembling a product is matched with revenues and reported in the period the goods are sold.

(e) Systematic and rational allocation. The delivery trucks are expected to benefit several accounting periods in a systematic and rational way.

(f) Immediate recognition. The advertising indirectly helps to generate rev-enues and is not related to specific revenues.

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4–26.

Original cost of patent....................................................................... $450,000Amortization for 5 years ($30,000 per year 2000–2004)............... 150,000 Remaining unamortized balance..................................................... $ 300,000

New estimated life from January 1, 2005....................................... 4 yearsAmortization expense for each year (2005–2008)......................... $75,000

Separate disclosure of the $45,000 increase due to the change in estimate would be required in 2005 if it is considered a material amount.

4–27.

(a) Subtracted or included in determining net purchases in the Cost of Goods Sold section

(b) Other revenues and gains(c) Other revenues and gains(d) Other expenses and losses(e) Either extraordinary items or other expenses and losses depending on

whether unusual and infrequent(f) Operating expenses—selling expenses(g) Discontinued operations(h) Deduction from income from continuing operations before income

taxes(i) Other revenues and gains(j) Subtraction from sales(k) Other expenses and losses(l) Cost of goods sold (an item entering into cost of goods manufactured)(m) Cumulative effect of change in accounting principle(n) Operating expenses—general and administrative(o) Cost of goods sold

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4–28.Caribou Inc.

Income StatementFor the Year Ended December 31, 2005

Sales....................................................................... $1,600,000 (a)Cost of goods sold:

Beginning inventory.......................................... $ 136,000Net purchases.................................................... 919,200 (b)Cost of goods available for sale...................... $1,055,200Less: Ending inventory..................................... 95,200

Cost of goods sold............................................ 960,000

Gross profit on sales............................................ $ 640,000Operating expenses:

Selling expenses................................................ $ 208,000 (c)General expenses (including bad debts)......... 272,000 (d) 480,000

Income before income taxesand extraordinary items.................................... $ 160,000

Income taxes......................................................... 48,000

Income before extraordinary items.................... $ 112,000Extraordinary gain (net of income taxes

of $9,000)............................................................. 21,000

Net income............................................................. $ 133,000

Earnings per share (e):Income before extraordinary items................. $0.86Extraordinary gain............................................. 0.16 Net income.......................................................... $ 1.02

COMPUTATIONS:(a) Sales

Income before income taxes as a percentage of sales:Sales................................................................ 100%Cost of goods sold (see below)................... 60 Gross profit on sales.................................... 40%Selling expenses........................................... 13%General expenses, including bad debts.. . 17 30

Income before income taxes.......................... 10 %

Sales: $160,000 (income before income taxes) ÷ 0.10 = $1,600,000Cost of goods sold:

General expenses, excluding bad debts = 15% of sales and 25% of cost of sales: therefore, 0.15 sales = 0.25 Cost of goods soldCost of goods sold = 0.15 ÷ 0.25 = 0.60 of sales

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4–28. (Concluded)

(b) Net purchasesCost of goods sold = Beginning inventory Net purchases less ending inventoryLet X equal net purchases.

0.60 $1,600,000 = $136,000 + X 0.70 ($136,000)$960,000 = $40,800 + XX = $919,200

(c) 0.13 $1,600,000 = $208,000

(d) (0.15 $1,600,000) + (0.02 $1,600,000) = $272,000

(e) Earnings per share (130,000 shares of common stock outstanding):Income before extraordinary gain: $112,000 ÷ 130,000 shares = $0.86Extraordinary gain: $21,000 ÷ 130,000 shares = $0.16Net income: $133,000 ÷ 130,000 shares = $1.02

4–29.Brigham Corporation

Income Statement (Partial)For the Year Ended December 31, 2005

Income from continuing operations before income taxes.............. $210,000Income tax expense on continuing operations ($210,000 0.35). 73,500

Income from continuing operations................................................... $136,500Discontinued operations:

Loss from operations of discontinued businesscomponent (including gain on disposal of $20,000) $ (30,000)Net income tax benefit................................................ 10,500 (19,500)

Extraordinary gain (net of income taxes of $49,000). 91,000

Net income............................................................................................. $ 208,000

4–30.

(a) Discontinued operations:Loss from operations of discontinued business component (including gain on disposal of $15,000)...................................................................... $(115,000)Income tax benefit..................................................... 34,500 $

(80,500 )

(b) If Garrison Manufacturing were reporting using the accounting stan-dards of the United Kingdom, it would also disclose information about sales and operating profits for the continuing and discontinued opera-tions. This additional information allows financial statement users to compare the relative size and operating profitability of the continuing and discontinued operations. This practice is also similar to the report-ing requirements of IFRS 35.

4–31.

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2005 2004 2003Sales $50,000 $43,000 $35,000Cost of goods sold 20,000 18,000 15,000Other expenses 13,000 12,000 11,000Income before income taxes $17,000 $13,000 $ 9,000Income tax expense (35%) 5,950 4,550 3,150Income from continuing operations $11,050 $ 8,450 $ 5,850Discontinued operations:

Income (loss) from operations(including gain on disposalin 2005 of $10,000) $3,000 $(5,000) $20,000

Income tax expense (benefit)—35% 1,050 (1,750) 7,000

Income (loss) on discontinued operations 1,950 (3,250) 13,000

Net income $13,000 $ 5,200 $18,850

4–32.(a) (In millions

of dollars)

Income from continuing operations............................................. $1,032.3Cumulative effect of change in accounting for income taxes(net of applicable taxes)................................................................. 544 .2 Net income....................................................................................... $ 1,576 .5

Earnings per common share:Income from continuing operations.......................................... $ 2.06Cumulative effect of accounting change.................................. 1.09 Net income.................................................................................... $ 3.15

(b) If Sears were a non-U.S. company reporting under the provisions of IFRS 8, the $544.2 million “gain” from the cumulative effect of the change in accounting principle would not be shown in the income statement at all. Instead, the $544.2 million amount would be shown as a direct adjustment (an increase) to the be-ginning balance in retained earnings for the year.

4–33.

(a) Sales revenue.

(b) Loss on disposal of discontinued operations; a separate component of income shown net of taxes before extraordinary items but after income from continuing operations.

(c) Extraordinary item, net of taxes.

4–33. (Concluded)

(d) Prior-period adjustment (error correction); retained earnings adjustment.

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(e) Operating expense (or reduction in revenue)—it is a change in estimate.

(f) Asset.

(g) Results of discontinued operations: a separate component of income shown net of taxes before extraordinary items but after income from continuing operations.

(h) Asset (possibly could be expensed).

(i) Prior-period adjustment (error correction); retained earnings adjustment.

(j) Other Revenues and Gains section of income statement.

(k) Other Expenses and Losses section of income statement unless the event is considered unusual and infrequent, in which case it would be reported as an ex-traordinary item.

(l) Cumulative effect of change in accounting principle; a separate component of income shown net of taxes as last item before net income.

(m) Operating expense; it is a change in estimate.

(n) Other Revenues and Gains section of income statement.

(o) Operating Expense or Other Expenses and Losses section, depending on nature of business unless the event is considered unusual and infrequent, in which case, it would be reported as an extraordinary item.

(p) Operating expense or adjustment to cost of goods sold.

(q) Included with current-year tax expense.

(r) Other Expenses and Losses section because the sale is only a portion of business segment.

(s) Operating expense because the move does not qualify as discontinued operations.

(t) Operating expense.

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4–34.Income Statement

Revenue:SalesLess: Sales discounts

Sales returns and allowances Cost of goods sold:

Inventory—beginningNet purchases:

PurchasesLess: Purchase discounts

Purchase returns and allowancesFreight-inCost of goods available for saleLess: Inventory—ending

Gross profitOperating expenses:

Selling expenses:Advertising expenseSales salaries and commissionsMiscellaneous selling expense

General and administrative expenses:Officers’ salaries expenseOffice salaries expenseOffice supplies expenseDepreciation expense—office buildingDepreciation expense—office furniture and fixturesBad debt expenseInsurance expenseProperty taxes expenseMiscellaneous general expense

Operating incomeOther revenues and gains:

Dividend revenueInterest revenueRoyalty revenue

Other expenses and losses:Interest expense—bondsInterest expense—other

Income from continuing operations before income taxesIncome tax expenseIncome from continuing operationsLoss from discontinued operations (net of income taxes of _____ )Extraordinary gain (net of income taxes of _____ )Net income

Earnings per common share:Income from continuing operationsLoss from discontinued operationsExtraordinary gainNet income

4–35.The Pensacola Awning Company

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Income StatementFor the Year Ended December 31, 2005

Sales revenue.............................................................. $1,380,000Expenses:

Costs of goods sold................................................ $765,000Selling expenses...................................................... 288,720General and administrative expenses.................. 236,400Interest expense...................................................... 13,390Income taxes............................................................ 30,596 (a) 1,334,106

Net income................................................................... $ 45,894

Earnings per share ($45,894 ÷ 25,000 shares)....... $ 1 .84

(a) 0.40 $76,490 (Income before taxes)

The Pensacola Awning CompanyStatement of Retained Earnings

For the Year Ended December 31, 2005

Retained earnings, January 1.......................................................... $444,500Add: Net income................................................................................ 45,894

$490,394Deduct: Dividends............................................................................. 45,000 Retained earnings, December 31.................................................... $ 445,394

4–36.1. Losser Corporation

Schedule of Corrected Net IncomeFor the Year Ended December 31, 2005

Reported net income (profit and loss)......................... $13,680Add: Change in amortization expense...................... $ 2,800

Gain on sale of land............................................ 18,350Interest revenue................................................... 4,500 25,650

$39,330Less: Increased depreciation—change in estimate.. $ 5,000

Loss on sale of equipment................................. 3,860Extraordinary casualty loss............................... 27,730 36,590

Corrected net income..................................................... $ 2,740

138

4–36. (Concluded)

2.Losser Corporation

Retained Earnings StatementFor the Year Ended December 31, 2005

Retained earnings, January 1, 2005................................................. $85,949Add: Net income.................................................................................. 2,740

$88,689Deduct: Dividends declared.............................................................. 10,000

Retained earnings, December 31, 2005........................................... $ 78,689

3. All items except dividends declared during the year would be reported on the income statement and included in net income. Extraordinary items would be reported separately after income from continuing operations.

4–37.1. The unrealized losses on available-for-sale securities will decrease compre-

hensive income because the value of the securities decreased during the year. The foreign currency translation adjustment will decrease comprehensive in-come because the value of the currencies of Svedin’s foreign subsidiaries weakened relative to the U.S. dollar. The minimum pension liability adjustment will decrease comprehensive income.

2. Svedin IncorporatedStatement of Comprehensive Income

For the Year Ended December 31, 2005Net income.............................................................................. $17,650Unrealized losses on available for sale securities............ (1,285)Foreign currency translation adjustment........................... (287)Minimum pension liability adjustment................................ (315 )Comprehensive income........................................................ $ 15,763

139

4-38. Han IncorporatedForecasted Income Statement


2006 2005 Forecasted

Sales................................................. $2,000 $2,200 givenCost of goods sold.......................... 700 770 35% of sales,

as last yearGross profit...................................... $1,300 $1,430Depreciation expense.................... 120 160 20% of PPE,

same as last yearOther operating expenses............. 1,010 1,111 50.5% of sales,

same as last yearOperating profit............................... $ 170 $ 159Interest expense.............................. 90 75 15% of bank loan,

same as last yearIncome before taxes....................... $ 80 $ 84Income taxes................................... 30 32 37.5% of pretax,

same as last yearNet income....................................... $ 50 $ 52

4-39.Ryan Company

Forecasted Balance SheetDecember 31, 2006


Cash.................................................. $ 10 $ 15 50% natural increase Other current assets...................... 250 375 50% natural increaseProperty, plant, and equipment,

net.................................................. 800 800 more efficient, item (b)Total assets..................................... $ 1,060 $ 1,190

Accounts payable........................... $ 100 $ 150 50% natural increaseBank loans payable........................ 700 900 new loan of $200,

item (c)Total stockholders’ equity............. 260 140 to balanceTotal liabilities and

stockholders’ equities................. $ 1,060 $ 1,190

140

4-39. (Concluded)

Ryan CompanyForecasted Income Statement



Sales................................................. $1,000 $1,500 given, item (a)Cost of goods sold.......................... 750 1,125 75% of sales,

same as last yearGross profit...................................... $ 250 $ 375Depreciation expense.................... 40 40 5% of PPE,

same as last yearOther operating expenses............. 80 120 8% of sales,

same as last yearOperating profit............................... $ 130 $ 215Interest expense.............................. 70 90 10% of bank loan,

same as last yearIncome before taxes....................... $ 60 $ 125Income taxes................................... 20 42 33.3% of pretax,

same as last yearNet income....................................... $ 40 $ 83

Note: Total stockholders’ equity is forecasted to decrease by $120 ($260 $140). This will happen even though net income will cause stockholders’ equity to increase by $83. These forecasts imply that Ryan Company is either planning to pay out a large cash dividend or to buy back a large amount of shares of its own stock.

141

PROBLEMS

4–40.Payette Co.

Income StatementFor the Year Ended June 30, 2005

Revenue: Sales ($2,380,000 less returns and

allowances, $30,000).............................................. $2,350,000Interest revenue........................................................ 52,000

$2,402,000Expenses:

Cost of goods sold (net purchases, $1,473,000 less increase in inventory, $10,000) $1,463,000

Selling and general expenses................................. 238,000Income taxes................................................................ 262,800 1,963,800 Net income.................................................................... $ 438,200 Earnings per common share

($438,200 ÷ 325,000 shares).................................... $ 1.35

Payette Co.Retained Earnings Statement

For the Year Ended June 30, 2005

Retained earnings, July 1, 2004................................. $1,356,800Add: Net income........................................................... 438,200

$1,795,000Deduct: Dividends....................................................... 260,000 Retained earnings, June 30, 2005.............................. $ 1,535,000

142

4–41.1. Income statement–time of shipment:

Richmond CompanyIncome Statement

For the Years Ended December 31

2006 2005 Sales................................................................................. $150,000 $125,000Cost of goods sold.......................................................... 90,000 75,000 Gross profit...................................................................... $ 60,000 $ 50,000Bad debt expense........................................................... (7,500) (6,250)Selling expenses............................................................. (15,000) (25,000)General and administrative expenses......................... (22,000 ) (22,000 )Net income (loss)............................................................ $ 15,500 $ (3,250 )

Income statement—time of sale:

Richmond CompanyIncome Statement

For the Years Ended December 31

2006 2005 Sales................................................................................. $132,000 $ 84,000Cost of goods sold.......................................................... 66,000 42,000 Gross profit...................................................................... $ 66,000 $ 42,000Bad debt expense........................................................... (660) (420)Selling expenses............................................................. (15,000) (25,000)General and administrative expenses......................... (22,000 ) (22,000 )Net income (loss)............................................................ $ 28,340 $ (5,420 )

2. Under the first dealer agreement, revenue is recognized when goods are shipped to the dealers. The dealer makes payment after receipt of the goods. Possible bad debt losses are greater under this agreement be-cause the dealer may not have the cash to pay for the toys until they are sold. The second type of dealer agreement is actually a consignment of inventory. Because there is a right of return, the revenue should not be recognized until the dealer makes a sale. The risk is borne by Rich-mond. To cover this risk, the sales price is higher for the toys.

In the problem, Richmond would have a larger loss in 2005 under the consignment agreement than under the sale agreement; however, in 2006 the consignment agreement would produce a greater profit. In ad-dition, at the end of 2006 Richmond will still have 19,000 units out on consignment, assuming that none of the units have been returned, with a potential profit of $3 per unit less bad debt costs. Of course, if these 19,000 units are returned and cannot be resold, this profit will not be re-alized. The uncertainty of the second type of dealer agreement justifies the delay of revenue recognition until the dealer makes a sale.

143

4–42.

1. (a) Revenue must be both earned and realized in order to be reported on the income statement. Until Hadley ships the inventory, the $18,000 of orders paid for in advance should not be reported on the income statement.

(b) Because customers are not returning the products, the earnings process can be considered substantially complete when the sale is made. The revenues and associated cost of goods sold should be in-cluded on the income statement.

(c) The rent will benefit several accounting periods and should be allocated in a systematic fashion.

(d) It is difficult to determine the period of time that is benefited by general advertising. Because the advertising costs cannot be related to specific revenues, the costs are typically recognized as expenses immediately.

(e) Current cost information is currently not disclosed on the face of the in-come statement. Some companies elect to provide supplemental infor-mation of this nature in the notes to the financial statements.

(f) If warranty costs can be reasonably estimated, the expenses are matched directly to the period in which the revenue is generated. Using the actual costs incurred to approximate warranty expense violates the matching principle.

2. Sales................................................................................................ $183,000Cost of goods sold........................................................................ 101,500 Gross profit.................................................................................... $ 81,500Rent expense................................................................................. (12,000)Advertising expense..................................................................... (24,000)Warranty expense......................................................................... (9,150)Other expenses.............................................................................. (15,000 )Net income..................................................................................... $ 21,350

Sales: $185,000 – $18,000 + $16,000 = $183,000

Cost of goods sold: $94,000 + $7,500 = $101,500

Rent expense: $18,000 – $6,000 = $12,000

Advertising expense: $6,000 + $18,000 = $24,000

Warranty expense: $183,000 0.05 = $9,150

144

4–43.Delaney Manufacturing Inc.Income Statement (Partial)

For the Fiscal Year Ended July 31, 2005

Income from continuing operations before income taxes...................... $1,014,000 (a)Incomes taxes................................................................................................ 304,200 (b)Income from continuing operations........................................................... $ 709,800Extraordinary gain (net of income taxes of $30,300)............................... 70,700 (c)Loss from disposal of a business component (net of income tax

savings of $42,000).................................................................................... (98,000 ) (d)Net income..................................................................................................... $ 682,500

COMPUTATIONS:(a) $975,000 – $101,000 + $140,000 = $1,014,000(b) $1,014,000 0.30 = $304,200(c) $101,000 0.30 = $30,300; $101,000 – $30,300 = $70,700(d) $140,000 0.30 = $42,000; $140,000 – $42,000 = $98,000

Delaney Manufacturing Inc.Retained Earnings Statement

For the Fiscal Year Ended July 31, 2005

Retained earnings, August 1, 2004............................................................. $2,750,000Less: Prior-period adjustment (net of income tax savings of $22,500). 52,500 (a) Adjusted retained earnings, August 1, 2004............................................. $2,697,500Add: Net income............................................................................................ 682,500 Retained earnings, July 31, 2005................................................................ $ 3,380,000

(a) $75,000 0.30 = $22,500; $75,000 – $22,500 = $52,500

145

4–44.Radiant Cosmetics Inc.

Income Statement (Partial)For the Year Ended December 31, 2005

Income from continuing operations before income taxes............... $210,000Income taxes ($82,000 + $20,000 – $8,000 – $10,000)....................... 84,000 Income from continuing operations.................................................... $126,000Discontinued operations:

Loss from operations of discontinued cosmeticsdivision (including loss on disposal of $50,000).......................... $(32,000)

Income tax benefit............................................................................... (12,000) (20,000)Extraordinary gain (net of income taxes of $10,000)........................ 15,000 Net income.............................................................................................. $ 121,000

Earnings per common share:Income from continuing operations ($126,000 ÷ 35,000 shares).. $ 3.60Loss from discontinued operations ($20,000 ÷ 35,000 shares).... (0.57)Extraordinary gain ($15,000 ÷ 35,000 shares)................................. 0.43 Net income........................................................................................... $ 3.46

Radiant Cosmetics Inc.Retained Earnings Statement


Retained earnings, January 1, 2005.................................................................... $620,000Add: Correction of sales understatement in 2004

(net of income taxes of $21,000)....................................................................... 39,000 $659,000

Deduct correction for omission of depreciation of prior periods (net of income tax refund claim of $8,000)...................................................... 12,000

Adjusted retained earnings, January 1, 2005..................................................... $647,000Add: Net income..................................................................................................... 121,000

$768,000Deduct: Dividends.................................................................................................. 40,000 Retained earnings, December 31, 2005.............................................................. $ 728,000

146

4–45.

Discontinued operations:Loss from operations of discontinued business component

(including loss on disposal of $5,000)...................................... $(94,900)

Income tax benefit.......................................................................... (33,215 )$

(61,685 )

The expected operating loss and the expected disposal gain in 2006 are not reported in the 2005 income statement. Before the release of SFAS No. 144 changed the ac-counting for discontinued operations, these two expected items would have been used to compute an “expected loss on disposal.”

4–46.

1. 2005 2004 2003

(a) Gross profit percentage.......................... 48.0% 52.0% 54.0%(b) Net profit percentage.............................. 7.0% 9.3% 12.9%(c) Price-earnings ratio................................. 13.7 18.1 20.9

2. While RoboCon’s sales are increasing every year, its gross margin is declining, resulting in a decreasing profit margin. The market is appar-ently aware of this information and is pricing the stock accordingly. Even though sales are increasing, the firm’s earnings multiple has de-clined each of the past 2 years.

147

4–47.Connell Company

Multiple-Step Income StatementFor the Year Ended December 31, 2005

Revenue:Sales............................................................................. $8,125,000Less: Sales discounts................................................ $ 55,000

Sales returns and allowances......................... 95,000 150,000 $7,975,000

Cost of goods sold:Inventory, January 1.................................................... $ 775,000Net purchases:

Purchases.................................................................. $4,633,200Less: Purchase discounts....................................... 47,700 4,585,500

Freight-in...................................................................... 145,000 Cost of goods available for sale................................. $5,505,500Less: Inventory, December 31 (net of write-down)... 750,000 4,755,500 Gross profit.................................................................. $3,219,500

Operating expenses:Selling expenses:

Sales salaries............................................................ $ 521,000Delivery expense...................................................... 425,000Depreciation expense—delivery trucks.................. 29,000Depreciation expense—store equipment............... 25,000Miscellaneous selling expenses............................. 50,000 $1,050,000

General and administrative expenses:Officers’ and office salaries..................................... $ 550,000Employee pension expense..................................... 190,000Property taxes expense........................................... 100,000Bad debt expense..................................................... 32,000Depreciation expense—office building................... 25,000Depreciation expense—office equipment.............. 10,000Miscellaneous general expenses............................ 45,000 952,000 2,002,000

Operating income........................................................... $1,217,500

Other revenues and gains:Dividend revenue......................................................... $ 35,000Interest revenue........................................................... 10,000Gain on sale of office equipment............................... 8,000 53,000

Other expenses and losses:Loss on sale of investment securities....................... (20,000 )

Income from continuing operations before income taxes................................................................... $

1,250,500Income taxes................................................................... 427,425 Net income...................................................................... $ 823,075

Earnings per share ($823,075 ÷ 60,000 shares)........... $ 13.72

148

4–47. (Concluded)Connell Company

Retained Earnings StatementFor the Year Ended December 31, 2005

Retained earnings, January 1, 2005................................................................. $ 550,000Add: Net income.................................................................................................. 823,075

$1,373,075Deduct: Dividends............................................................................................... 150,000 Retained earnings, December 31, 2005........................................................... $ 1,223,075

149

4–48.Jericho Recreation, Inc.


Revenue:Sales.......................................................................... $797,500 (a)Less: Sales returns and allowances..................... 9,500 $788,000

Cost of goods sold..................................................... 302,800 (b)

Gross profit................................................................. $485,200Operating expenses:

Selling expenses:Sales salaries and commissions........................ $160,000Depreciation—stores and store equipment...... 33,600 (c)Advertising expense............................................ 13,400 $207,000

General and administrative expenses:Officers’ and office salaries................................ $210,000Depreciation—office building and equipment. . 22,400 (c)Other general and administrative expenses..... 38,800 271,200 478,200

Operating income....................................................... $ 7,000Other revenues and gains:

Interest revenue....................................................... $ 6,600Gain on sale of land and building.......................... 40,000 (d) 46,600

Other expenses and losses:Interest expense...................................................... $ (10,600)Loss on sale of short-term investment................ (3,000 ) (13,600 )

Income before income taxes, extraordinary item,and cumulative effect.............................................. $ 40,000

Income taxes (30%).................................................... 12,000 Income before extraordinary item and

cumulative effect..................................................... $ 28,000Extraordinary gain

(net of income taxes of $4,800).............................. 11,200Cumulative effect of change in inventory costing

method (net of income tax savings of $5,400)..... (12,600 )Net income................................................................... $ 26,600

Earnings per common share:Income before extraordinary item and cumulative effect............................ $ 2.80Extraordinary gain............................................................................................. 1.12Cumulative effect of accounting change........................................................ (1.26 )Net income.......................................................................................................... $ 2.66

4–48. (Concluded)

COMPUTATIONS:

(a) Sales: $797,000 + $9,500 – $6,600 + $10,600 + $3,000 – $16,000 = $797,500

(b) Cost of goods sold: $320,800 – $18,000 = $302,800. The $18,000 cumulative ef-fect of change in inventory method is reported separately, net of 30% tax sav-ings, as a nonoperating component of income.

(c) Depreciation: Stores and store equipment, $56,000 0.60 = $33,600Office bldg. and equipment, $56,000 0.40 = $22,400

(d) The total pre-tax gain of $40,000 is included in income from continuing opera-tions. The sale of land and building does not constitute the disposal of a busi-ness component.

4–49.Rollins Sporting Goods


Sales............................................................................. $103,200 (a)Cost of goods sold:

Beginning inventory................................................ $ 10,020Purchases................................................................. 53,540 (b)Goods available for sale......................................... $ 63,560Less: Ending inventory........................................... 18,665 (d) 44,895

Gross profit................................................................. $ 58,305 (c)Operating expenses:

Selling expenses...................................................... $ 11,661General and administrative expenses.................. 25,800 (e) 37,461

Income before taxes................................................... $ 20,844Income taxes............................................................... 8,338 (f)Net income................................................................... $ 12,506

Earnings per share ($12,506 ÷ 6,000 shares)......... $ 2.08

COMPUTATIONS:(a) Cash collections.................................................................. $107,770

Accounts receivable, December 31, 2004....................... (20,350)Accounts receivable, December 31, 2005....................... 15,780 Sales...................................................................................... $ 103,200

4–49. (Concluded)

(b) Cash payments.................................................................... $ 96,350Accounts payable, December 31, 2004............................ (9,870)Accounts payable, December 31, 2005............................ 5,175Cash general and administrative expenses.................... (22,704)*Selling expenses................................................................. (11,661)Wages and salaries payable, December 31, 2004.......... (3,750 )

Purchases.......................................................................... $ 53,540

*Total general and administrative expenses(0.25 $103,200).............................................................. $ 25,800Less depreciation on store equipment......................... 3,096 (g)Cash general and administrative expenses................. $ 22,704

(c) Selling expense $11,661 ÷ 0.20 = $58,305 gross profit

(d) Sales (a)................................................................................ $103,200Gross profit (c)..................................................................... 58,305

Cost of goods sold.......................................................... $ 44,895Beginning inventory............................................................ (10,020)Purchases (b)....................................................................... (53,540 )

Ending inventory............................................................. $ (18,665 )

(e) Sales $103,200 0.25 = $25,800 general and administrative expenses

(f) Income before income taxes $20,844 0.40 tax rate = $8,338 income taxes

(g) General and administrative expenses $25,800 0.12 = $3,096 depreciation

4–50.

Sunset Cosmetics Inc.Multiple-Step Income Statement


Revenue:Sales.......................................................................... $499,400 (a)Less: Sales returns and allowances...................... $ 11,200

Sales discounts............................................. 880 12,080 $487,320Cost of goods sold:

Inventory, January 1................................................. $ 89,700Net purchases:

Purchases............................................................... $173,000Less: Purchase returns and allowances............. 10,380 (b) 162,620

Freight-in................................................................... 6,325 (c)Cost of goods available for sale.............................. $258,645Less: Inventory, December 31................................. 54,150 (d) 204,495 Gross profit............................................................... $282,825

Operating expenses:Selling expenses:

Sales salaries and commissions.......................... $ 35,108 (e)Advertising expense.............................................. 16,696 (f)Depreciation expense—sales/delivery

equipment............................................................ 6,750 (g)Freight expense..................................................... 4,200Travel expense—sales representatives............... 4,560Miscellaneous selling expenses.......................... 2,200 $ 69,514

General and administrative expenses:Officers’ salaries expense................................... $ 36,600Insurance and licenses........................................ 8,500Bad debt expense................................................. 7,460 (i)Utilities expense................................................... 6,400Depreciation expense—office equipment.......... 4,800Legal services...................................................... 2,225Telephone and postage expense........................ 1,475Supplies expense................................................. 580 (h) 68,040 137,554

Operating income........................................................ $145,271Other revenues and gains:

Interest revenue........................................................ $ 1,390 (j)Dividend revenue...................................................... 7,150Gain on sale of assets.............................................. 18,500 $ 27,040

Other expenses and losses:Interest expense....................................................... (4,520 ) 22,520

Income from continuing operations beforeincome taxes................................................................ $167,791Income taxes................................................................ 58,727 (k)Income from continuing operations........................... $109,064Discontinued operations:

Gain from discontinued operations (net of income taxes of $14,000)...................................... 26,000

Extraordinary loss (net of income tax savings of $25,410)................................................................. (47,190 )

Net income................................................................... $ 87,874

4–50. (Concluded)

Earnings per common share:Income from continuing operations ($109,064 ÷ 39,000 shares)................. $ 2.80Gain from discontinued operations ($26,000 ÷ 39,000 shares).................... 0.67Extraordinary loss ($47,190 ÷ 39,000 shares)................................................. (1 .21 )Net income ($87,874 ÷ 39,000 shares = $2.25*)............................................... $ 2 .26 *

*Difference due to rounding.

COMPUTATIONS:

(a) Sales: $495,200 + $4,200 = $499,400

(b) Purchase returns and allowances: $173,000 0.06 = $10,380

(c) Freight-in: $5,525 + $800 = $6,325

(d) Inventory: $20,550 + $33,600 = $54,150

(e) Sales salaries and commissions: $35,000 + ($3,600 0.03) = $35,108

(f) Advertising expense: $16,090 + ($1,818 2/6) = $16,696

(g) Depreciation expense: $6,100 + ($7,800 10/120) = $6,750

(h) Supplies expense: $2,180 – $1,600 = $580

(i) Bad debt expense: ($261,000 0.03) – $370 = $7,460

(j) Interest revenue: $700 + $690 = $1,390

(k) Income taxes: $167,791 0.35 = $58,727

Sunset Cosmetics Inc.Retained Earnings Statement


Retained earnings, January 1............................................................................... $440,670Add: Net income..................................................................................................... 87,874

$528,544Deduct: Dividends.................................................................................................. 33,000 Retained earnings, December 31......................................................................... $ 495,544

4–51.

Before preparing the statement of comprehensive income, net income must be com-puted, as follows:

Revenues and gains:Sales................................................................................................ $450,000Gain on sale of investment.......................................................... 6,700

Total revenues and gains.......................................................... $456,700Expenses and losses:

Cost of goods sold........................................................................ $263,000Selling expenses........................................................................... 63,900General and administrative expenses........................................ 58,720Income tax expense...................................................................... 21,500

Total expenses and losses........................................................ 407,120 Income from continuing operations.............................................. $ 49,580Extraordinary gain, net of income taxes....................................... 39,400Cumulative effect of change in depreciation method,

net of income tax savings............................................................ (18,380 )Net income........................................................................................ $ 70,600

Note: The sale of the land did not produce a gain or a loss; therefore, the proceeds are not included in the statement. Dividends paid are part of the retained earnings statement and are also excluded from the preceding statement. The correction of the inventory error is a prior-period adjustment and is shown as a direct adjustment to the beginning balance in retained earnings; it does not enter into the computation of net income or of comprehensive income.

Blacksburg CompanyStatement of Comprehensive Income


Net income.............................................................................................................. $ 70,600Other comprehensive income:

Foreign translation adjustment, net of income taxes.................................... 33,000 Comprehensive income........................................................................................ $ 103,600

4-52.

1. Lorien CompanyForecasted Balance Sheet

December 31, 2006

20062005 Forecasted

Cash............................................................ $ 40 $ 48 20% natural increaseOther current assets................................. 350 420 20% natural increaseProperty, plant, and equipment, net....... 1,000 800 $1,000 – $200;

no replacementsTotal assets................................................ $ 1,390 $ 1,268

Accounts payable..................................... $ 100 $ 120 20% natural increaseBank loans payable................................... 1,000 1,000 no new loans, item (c)Paid-in capital............................................ 100 (147) to balanceRetained earnings..................................... 190 295 $190 + $120 – $15Total liabilities and stockholders’

equity....................................................... $ 1,390 $ 1,268

Lorien CompanyForecasted Income Statement


20062005 Forecasted

Sales........................................................... $1,000 $1,200 given, item (a)Cost of goods sold.................................... 350 420 35% of sales,

same as last yearGross profit................................................ $ 650 $ 780Depreciation expense............................... 200 200 same as last year;

no replacements*Other operating expenses....................... 250 300 25% of sales,

same as last yearOperating profit......................................... $ 200 $ 280Interest expense........................................ 120 120 12% of bank loan,

same as last yearIncome before taxes................................. $ 80 $ 160Income taxes.............................................. 20 40 25% of pretax,

same as last yearNet income................................................. $ 60 $ 120

*One could also argue that depreciation expense will be lower in 2006 because the net amount of property, plant, and equipment will decline.

4-52. (Concluded)

2. Yes, it is possible for paid-in capital to be negative. This means that a company has spent more to repurchase shares of its own stock than was initially invested by shareholders. This is possible when share prices have increased significantly since shares were first issued. As with this example, negative paid-in capital is symptomatic of a company that has generated much excess cash and has used it to buy back shares. Coca-Cola is an example of a real-world company with net negative paid-in capital.

DISCUSSION CASES

Discussion Case 4–53

This case demonstrates how a change in an accounting principle may make an enterprise’s financial statements more comparable with those of other enterprises but cause its current year’s statements to be noncomparable with its prior years’ statements. Thus, the principle of consistency is violated. Accounting standards do permit an enterprise to change its accounting principles. However, there must be full disclo-sure of the change, including data revealing its impact on current financial statements.

Usually, information concerning an accounting change is contained in a note to the financial statements. If a cumulative adjustment is necessary for past events, it should be reported as a separate income state-ment item. In this case, the change affected depreciation. If prior years’ depreciation is adjusted to the straight-line method, a cumulative adjustment would be necessary to restate the accumulated deprecia-tion for the equipment. If only current and future years’ depreciation is affected by the change, no cumula-tive adjustment would be involved. In either case, a note describing the change and indicating the impact on income, earnings per share, and asset valuation would be required. A more complete discussion of accounting changes is provided in a later chapter.


Two different aspects of this case should be explored with students. First, there is no necessary connec-tion between income and cash. Cash payments may be made for purposes other than expenses, such as equipment purchases. In addition, changes in the amounts of accounts receivable and accounts payable affect cash but usually not income. Second, the increasing cost of inventory and supplies means that if a company maintains the same quantity and quality of inventory and supplies, more cash will be required. The replacement cost of goods sold in the past 2 years has been $90,000 more than what it cost origi-nally to buy those goods. This alone could account for the cash flow shortage.

This case can be used to emphasize the difference between financial capital maintenance income and physical capital maintenance income. Because the company’s financial statements are prepared on the basis of a financial capital maintenance concept, and Stevenson is withdrawing most of the reported net income, it is not possible to maintain the company’s physical capital when prices are rising unless he in-vests more money into the business.


This case presents some interesting points for class discussion. The final decision will probably be pref -aced by “It depends . . .” Students should use the revenue recognition criteria of the conceptual frame-work as a basis for their decision. The first suggested revenue recognition point, completion of produc-tion, probably fails the realized or realizable test. Until the product is actually sold, the asset is not readily convertible to cash. If the artist’s reputation is established, sales could be made from design drawings or small sample sculptures. If the sales contract is firm, the realizability test could be met prior to actual de-livery. It appears clear that the second criterion, substantial completion of the activity or task, occurs upon completion of the sculpture as it is cast in bronze. Thus, revenue could be recognized at completion of production. The revenue recognition decision thus depends on when the sale is actually made.

The second suggested revenue recognition point, point of delivery of the product to the customer, implies that both criteria are met. The sale has been made, and substantial completion must have occurred be-cause delivery is made. The remaining uncertainty revolves around the return privilege. If there is a high likelihood of return, it could be argued that no sale has really occurred until the year is over. The buyer may be considered to be a borrower of the sculpture—an agent who has a year to decide whether to buy or not. The matching principle requires that an estimate of sales returns be made and recorded as an off-set to recognized revenue. If past experience provides a basis for this estimate, revenue recognition at the point of delivery seems justified. If, however, an estimate of the extent of returns is not possible, rev-enue recognition may have to wait until the end of the return period. The FASB has considered the right of return as a separate issue. It is discussed in Chapter 8. The case as written does not contain enough information to know whether an estimate of the expected returns is possible.


This case introduces the student to an arrangement that is similar to a consignment, even though the term is not used. Factors indicating that no revenue should be recognized until the dealer completes a sale to a third party are as follows:

No payment is required until the final sale has been made. Skyways may request a return of the dishes at its discretion. No interest is charged on the receivable until a sale to a third party is completed. Purpose of the arrangement is to induce dealers to stock larger amounts of inventory.

There are also factors that suggest a sale has occurred: (1) There are no specific provisions for return of the merchandise, and (2) prior returns have been nominal at 10%.

The revenue recognition criterion of realized or realizable does not appear to be met in this case until the sale to a third party is consummated. This would be especially true if the dealers were in any way related to Skyways. This case demonstrates how difficult it can be to apply revenue recognition principles in real-world situations.


This case presents students an interesting problem when adjustments to the financial statements are made based on estimates. Since the product line did not qualify as a business component, any losses would be reported as part of ordinary income unless it was decided they met the criteria for an extraordi-nary loss. If the expected loss is probable and if a reliable estimate of the amount can be made, account -ing standards would require accruing the loss in 2004. If either of these conditions is not met, disclosure by note to the financial statements would be sufficient to meet the standards. When the line is not discon-tinued in 2005, a reversal of the accrual would be necessary. The reversal should be reported in the same way as the accrual. Due to the nature of the item, separate line disclosure of the accrual and the reversal should probably be made. (Note: According to SFAS No. 146, estimates of losses associated with asset write-downs should be included in a restructuring charge, but estimates of future liabilities ex-pected to be created by the restructuring may not be included in the initial recorded amount of the re-structuring charge.)


The question of how to record research costs for computer software has been a controversial one. It is similar to the question of how to record research and development costs in general. The arguments to support deferring the cost center on better matching of costs against revenues. Until the software is de-veloped and marketed, no revenue is generated. By deferring the costs associated with the software, amortization of the costs against revenues can be made as sales are made. If a company has a history that permits reasonable estimates of the probability of success, use of these statistics to defer software development costs could lead to more useful financial statements.

Arguments to support expensing these costs center on the uncertainty of knowing whether a given piece of software will be successful in the marketplace. Until the prospects of sales are probable, any costs as-sociated with development of software should be expensed. A company with past successes can give no assurance that such success will continue.

Class discussion might address the issue of whether increased comparability occurs just because a uni-form method of accounting treatment is used. Companies differ in their ability to generate successful soft-ware; any accounting method that ignores these differences by developing uniform criteria could produce misleading financial statements. The FASB statement on software costs (Statement of Financial Ac-counting Standards No. 86) requires the expensing of all costs incurred before technological feasibility is established. Costs incurred after technological feasibility and before production are capitalized and amor-tized.


This case provides an opportunity to discuss the nature of assets in general and deferred charges in par-ticular. The discussion should also stress the importance of properly matching the expiration of asset costs with recognized revenues in order to report a proper income measure. Finally, students should be made aware that FASB Statement No. 7 requires development stage enterprises to report on the same basis as established operating enterprises. It is not considered proper accounting to capitalize operating losses. If such losses are expected, that knowledge can be incorporated into the decision being made. However, deferred charges should be limited to those costs that promise to provide future revenues. The loss in the early months of a branch’s life does not guarantee future excess of revenues over expenses. Misleading indications would be communicated if such items were deferred.


The adjustment of financial statements subsequent to their release has caused considerable discussion within the profession. Although the students have not yet been exposed to many of the conditions that cause changes to be made to previously issued financial statements, the issue is one that can be fruitfully discussed at this point. Comparability is the accounting principle used to justify requiring an adjustment to prior years’ income statements to reflect the discontinuance of a business component. If the current year’s income statement deletes the revenues and expenses for the discontinued business component from the operating section, the prior years’ statements reported with the current statement should be ad-justed in a similar manner. This will permit a reader to evaluate trend changes and separate the effect of discontinuing the business component from the other operations of the enterprise.

The controller’s objection is valid. Careful readers of financial statements are often confused by the changing numbers that appear in subsequent years in statements previously issued. Such changes are required in many other areas. The instructor might indicate some of these in the discussion. They include mergers, some changes in accounting principles, accounting errors, stock dividends and stock splits when computing earnings-per-share data, and so on. Unless readers are aware that these subsequent events or discoveries can cause prior statements to be adjusted, they may place less trust in the validity of the issued statements.


1. Revenues can be booked in advance by a company’s recording the journal entry prior to meeting the revenue recognition criteria. The typical journal entry would involve debiting a receivable account and crediting a revenue account.

Expenses can be deferred using two methods. The first is simply not to make any journal entry. The second is to record the expense as prepaid and to classify it as an asset on the balance sheet rather than as an expense on the income statement. It would then be expensed at some future time.

2. In many cases, top executives encourage misleading accounting practices because their compensa-tion is based, in part, on accounting numbers. If the numbers can be manipulated to portray favor-able news, the executives receive raises, bonuses, and so forth.

3. Again, students should be made aware that the business world presents ethical dilemmas. While textbooks provide the rules to be applied in a sterile environment, the dynamic environment of life of -ten presents individuals with quandaries for which there are no easy solutions. This question can lead to an interesting difference in opinion among students.

4. Independent auditors have a responsibility to prepare an audit to detect material misstatements. The objective of an audit is not to guarantee the accuracy of financial statements but to ensure that the financial statements are prepared in accordance with GAAP.

Some frauds are so carefully constructed and concealed that auditors could not reasonably be ex-pected to uncover the fraud. The legal system is called on to evaluate the auditor’s liability. Typi-cally, the courts evaluate the auditor using three qualifying questions: (1) Were the auditor’s actions in accordance with the duty expected of a professional? (2) Did individuals rely on the information audited by the auditor? and (3) Were damages incurred as a result of this reliance? The answers to these questions determine the extent of the auditor’s liability, especially under common law. Under some statutory law, criteria (2) and (3) are not required.


1. To be recognized, revenue must, in most cases, meet two criteria: (1) Goods or services are pro-vided to the buyer and (2) payment or a valid promise of payment must be received by the seller.

In the RJR Nabisco example, cigarettes were shipped to wholesalers (criterion No. 1), but the whole-salers had made no promise to pay for the cigarettes (criterion No. 2). In fact, rather than pay, wholesalers returned the inventory. In the Regina example, by recording goods when they were or-dered rather than when they were shipped, Regina violated the first criterion. Goods were not pro-vided to buyers.

In both instances, revenue was booked before both revenue recognition criteria had been met.

2. The revenue recognition criteria are not a function of contracts. The criteria are based on business events. If the business events occur, revenue is recognized. A legal contract may state any number of things, but in most cases, until goods or services are provided and a promise of payment is re -ceived, revenue should not be recognized. The arrangement is really a consignment of inventory.

3. For many businesses, inventory is shipped the same day a customer places the order. In these cases, it does not matter if the journal entry is made when the order is placed or when the goods are shipped.

In other cases, there may be a delay between the order and the shipment dates. Inventory may have to be produced, materials ordered, or paperwork processed. In these cases, one must make sure that the transaction giving rise to the revenue and the resulting journal entry are recorded in the same accounting period.

The problem in the Regina example was that revenue was being booked in one year and actually being earned in the next year. This resulted in erroneous annual financial statements.

4. Regina’s chief accountant elected to go along with the company president’s activities and, as a re-sult, spent six months in jail and was fined $25,000. The point of this question is not to provide spe-cific alternatives for dealing with fraud but rather to make students aware that fraudulent activities exist and that students must be prepared to deal with them in their role as accountants.


The purpose of this case is to help students understand the relationships between net income, gross profit percentage, and return on sales and the different ways in which profitability may be determined.

Drug store:Net income $1,050,000 $950,000 – $39,500 = $60,500Gross profit percentage $100,000/$1,050,000 = 9.5%Return on sales $60,500/$1,050,000 = 5.8%

Department storeNet income $670,000 – $560,000 – $66,500 = $43,500Gross profit percentage $110,000/$670,000 = 16.4%Return on sales $43,500/$670,000 = 6.5%

The drug store has the higher net income, but the department store has a higher profit percentage. As to which is more profitable, additional information would be required. However, this case illustrates that us-ing only one measure of profitability can often lead to an incomplete picture.

SOLUTIONS TO STOP & THINK

Stop & Think (p. 168): It would seem that the physical capital maintenance concept would provide the best theoretical measure of "well-offness." What difficulties would be encountered by a firm as it tried to turn theory into practice if the FASB had adopted the physical capital maintenance concept of measuring income?

Measuring physical well-offness would require firms to obtain fair market value measures of each of their assets and liabilities each period. The difficulties of obtaining these measures along with the associated costs would, in most cases, cause the costs of the information to exceed its benefits.

Stop & Think (p. 170): Why is it important to separately disclose revenues and gains? expenses and losses?

Revenues and expenses are associated with what a business does. That is, they relate to a company's central activity. An investor or creditor would want to evaluate a business's performance in its central ac-tivity. Additional information relating to gains and losses associated with the peripheral activities of a business would be useful but should not be combined with revenues and expenses for disclosure purposes.

Stop & Think (p. 172): Why do you think Kinross waits to recognize revenue from the sale of Kubaka gold until the gold is actually sold?

Recall that revenue recognition at the time of production is acceptable when sale at an established price is practically assured. For the gold produced by Kinross in eastern Russia, enough uncertainty surrounds the shipment and sale of the gold that revenue is not recognized until the actual sale occurs.

Stop & Think (p. 177): Having just reviewed a single-step and a multiple-step income statement, which type do you think provides better information for assessing a firm's performance?

Students' responses will vary in answering this question. Remind students that it is not their answer that is important; it is the thinking about the question that is of value.

SOLUTIONS TO STOP & RESEARCH

Stop & Research (p. 171): Use the SEC’s EDGAR system (accessed through http://www.sec.gov) to find the most recent 10-K filing of Service Corporation International (SCI).1. What is SCI’s business?2. What is SCI’s revenue recognition policy?

1. Service Corporation International is the largest funeral and cemetery company in the world. As of December 31, 2001, SCI operated 3,099 funeral service locations, 475 cemeteries, and 177 crema-toria located in 11 countries.

2. SCI sells price-guaranteed, prearranged funeral contracts through various programs providing for fu-ture funeral services at prices prevailing when the agreements are signed. Revenues associated with sales of prearranged funeral contracts are deferred until such time that the funeral services are performed. Sales of at-need cemetery interment rights, merchandise, and services are recognized when the service is performed or merchandise delivered. Preneed cemetery interment right sales of constructed cemetery burial property are not recognized until a minimum percentage (10%) of the sales price has been collected.

Stop & Research (p. 179): Each year, Fortune magazine compiles a list of the 500 largest companies in the United States. The rankings in this “Fortune 500” are determined by reported revenues. Find the most recent Fortune 500 listing and identify the ten largest companies in the United States (ranked by rev-enue).

The Fortune 500 list can be viewed using Fortune’s Web site at http://www.fortune.com. According to the 2002 listing, the following ten companies had the highest reported revenues in the United States:Rank Company Revenues

(in millions)

1 Wal-Mart Stores $219,812.0

2 ExxonMobil 191,581.0

3 General Motors 177,260.0

4 Ford Motor 162,412.0

5 Enron 138,718.0

6 General Electric 125,913.0

7 Citigroup 112,022.0

8 ChevronTexaco 99,699.0

9 International Business Machines 85,866.0

10 Philip Morris 72,944.0

http://www.fortune.com/lists/F500/snap_1047.html









SOLUTIONS TO NET WORK EXERCISES

Net Work Exercise (p. 166): In its 2001 annual report, AT&T reports 1998 revenue to be $47,817 million and 1998 net income to be $5,052 million. As a company acquires new businesses and sheds old busi -nesses (as AT&T has done many times), it retroactively goes back and restates its past financial state-ments to reflect its results as if the current company, and its subsidiaries, had been a functioning unit all along.

Net Work Exercise (p. 194): On March 8, 2002, the P/E ratios were as follows:

Coca-Cola 36.1

PepsiCo 34.8

General Motors 25.5

Ford n/a Ford had negative earnings in the most recent year.

Kmart n/a Kmart also had negative earnings in the most recent year.

Wal-Mart 36.9

SOLUTIONS TO BOXED ITEMS

Polluted Accounting (p. 180)

1. One might say that capitalizing the costs of certain expenditures does not affect the income state-ment at all. After all, when an expenditure that has been paid in cash, for example, is capitalized, only two asset accounts are involved. The effect on the income statement is detrimental when the expenditure should have been recorded as an expense rather than as an asset. If an expenditure properly classified as an expense is incorrectly recorded as an asset, income will be overstated. This is illustrated with the following journal entries:

What was done: Asset.................................. xxxCash............................. xxx

What should have been done: Expense.............................. xxxCash............................. xxx

2. Obviously, there is no straightforward answer to this question. The students should recognize the potential ethical dilemmas they may face as they enter the accounting profession and the business world.

3. Many independent auditors leave their audit firms to take employment with a client. In the vast ma-jority of these cases, everyone benefits. By auditing the firm for several years, the audit partner has gained valuable knowledge regarding the workings of that business that could be very useful to the client. However, care must be taken to ensure that an adequate control environment is in place to guard against any one person or group of people being able to manipulate the accounting records.

Phar-Mor and the World Basketball League (p. 182)

1. Inventory can either be sold or is on hand. If it is sold, it is disclosed on the income statement as cost of goods sold. If the inventory is on hand, it is disclosed on the balance sheet. If the balance sheet account is overstated, cost of goods sold is understated, resulting in an increase in net in-come. Overstating receivables causes an overstatement of sales, resulting in an increase in net in-come. As you can easily see, when these two frauds are combined, the effect on net income can be substantial.

A number of reasons exist to explain why anyone would inflate reported income. Higher than ex-pected income can have a positive effect on stock price. It can have a positive effect on the likeli -hood of raising additional capital or of obtaining loans. Higher net income, if tied to an executive's compensation, will obviously benefit the executive as well.

2. The independent auditor has the responsibility of examining the financial statements of a company and determining whether the amounts included in the statements fairly present the company's posi-tion as of a given date and the net income earned over a specified period. An auditor examines many different kinds of evidence before an opinion can be rendered. The internal control structure of the company, management's integrity, and the quality of the accounting system must be carefully considered to determine the quantity and quality of evidence that must be gathered. Several of the weaknesses mentioned in the description of Phar-Mor should probably have been discovered by the auditor and the impact of the weaknesses on the financial statements considered. Vendor confirma-tions, surprise inventory observations, analytical reviews, review of large cash disbursements, and other such procedures should have raised sufficient questions for the auditor to uncover the massive misstatements that were subsequently uncovered. Auditors are held responsible for exercising due care in performing their duty to render audit opinions on financial statements. If they fail to perform that duty carefully, they are, and should, be subject to the litigation being brought against them. Many times fraudulent activities are very difficult to uncover by the auditor if extensive management collusion exists.

3. Auditors are being encouraged to become very familiar with not only the company being audited but also the key financial players in a company and any outside activities that might reflect on the com-pany being audited. Auditors should become familiar with the industry and the financial climate in which the client is operating and be alert to any information that might suggest a conflict of interest on the part of management. Such information may be found in financial magazines and newspapers, discussions with other auditors and with company personnel, television and radio broadcasts, and so on. The significant amount of litigation against CPA firms has created an increased awareness of care on the part of all auditors. Auditors must keep their ears and eyes open to anything that might suggest a problem in the financial reporting.

COMPETENCY ENHANCEMENT OPPORTUNITIES

Deciphering 4–1 (The Walt Disney Company)

1. In 2001, Disney had two below-the-line items. Both were cumulative effects of changes in accounting principle. One change, resulting in a negative cumulative effect of $228 million, resulted from the ap-plication of AICPA SOP 00-2 on the accounting for film revenues and costs. The other change, re-sulting in a negative cumulative effect of $50 million, resulted from the adoption of SFAS No. 133 on derivative accounting.

2. There were three major reasons for the large decrease in net income from 2000 to 2001. The first two reasons are the negative cumulative effects described in part (1). The third factor is the $1,454 million restructuring and impairment charge reported in 2001.

3. Disney reported a net loss of $158 million in 2001. If all of the income statement items reported in 2001 are viewed as permanent aspects of Disney’s operations, then a loss of $158 million is a good first guess in terms of forecasting 2002 net income. However, the three items discussed in part (2) causing the decline in Disney’s 2001 income are all one-time items that will probably not be repeated in 2002. Thus, in forecasting 2002 net income we should add back the $228 million and the $50 mil-lion cumulative effects of changes in accounting principle. In addition, the $1,454 million restructuring and impairment charge is (hopefully) an item that will not be repeated in 2002. This item is reported before income taxes because it is an above-the-line item. In Note 6 to the financial statements, we learn that Disney’s income tax rate if 42.5% (federal plus state), so the after-tax amount of the re-structuring charge is $836 million [$1,454 × (1 0.425)]. A first estimate of 2002 net income is then computed as follows:

Net loss reported in 2001 (in millions) $(158)Add: Film accounting cumulative effect 228

Derivative accounting cumulative effect 50After-tax amount of restructuring charge 836

Initial estimate of 2002 net income $ 956

Interestingly, this forecast of 2002 net income is almost the same as was reported net income in 2000, suggesting that the reported results in 2001 differed from 2000 only because of the one-time items.

4. During the Internet stock bubble, P/E ratios for Internet stocks were often over 100. To take advan-tage of this, Disney separated its Internet Group and issued shares of stock having ownership rights to the future income to be generated by the Internet Group. By doing this, Disney hoped to make its Internet operations more visible to the market; if the results were merely lumped in with the overall corporate results, the market might not value the Internet-related income with the high P/E multiples given to other Internet stocks. Of course, after the collapse of the Internet stock bubble in 2000 and 2001, there was no longer any advantage to be gained by having a separately traded Internet Group stock.

5. At the bottom of its statement of stockholders’ equity, Disney provides a brief statement of compre-hensive income. For 2001, comprehensive income was a negative $120 million, computed as follows:

Net loss (in millions) $(158)Cumulative effect of adopting SFAS No. 133 (accounting for derivatives) 60Foreign currency translation, and other (22)Comprehensive income $(120)

6. In Note 11 to the financial statements, we learn that the media networks segment had both the high-est reported revenue ($9,569 million) and the highest operating income ($1,758 million). The parks and resorts segment had the highest operating profit margin; the operating profit margins for the four segments are as follows:

Media networks 18.4%Parks and resorts 22.6 Studio entertainment 4.3Consumer products 15.5

7. In Note 11 relating to segments, Disney discloses that 83% ($20,970/$25,269) of its revenues origi-nate in the United States and Canada.

8. Note 1 details the company's revenue recognition policies. “Broadcast advertising revenues are rec-ognized when commercials are aired. … Revenues from advance theme park ticket sales are recog-nized when the tickets are used.”

9. In Note 1, Disney reports that “Film and television production and participation costs are expensed based on the ratio of the current period's gross revenues to estimated total gross revenues from all sources on an individual production basis.” From this note, we can conclude that Disney uses a method of systematic and rational allocation.

10. Parks, resorts, and other properties are expensed on a straight-line basis over a time period ranging from 3 to 50 years.

Deciphering 4–2 (Pfizer)

1.

2001 2000 1999 a. Net income/Revenues 24.1% 12.7% 18.2% b. Cost of sales/Revenues 15.6 17.1 20.5 c. Research and development expenses/Revenues 15.0 15.1 14.9 d. Advertising expense/Revenues 8.9 10.8 11.3

2. The most interesting trend in the numbers computed in part (1) is the steady research and develop-ment expense as a percentage of revenues. Because research is the lifeblood of its business, it ap-pears that Pfizer has decided to plow 15% of revenues each year back into research. The numbers also show the very high profit margins in the pharmaceutical industry; cost of sales as a percentage of revenues is less than 20% in the two most recent years. Of course, this is balanced by the high ex-penditure for research and development (which is good from the standpoint of society) and for adver-tising (which does not necessarily add value to society as a whole).

3.

2001 2000 1999Provision for taxes on income 2,561 2,049 1,968Income from continuing operations before provision for taxes on income and minority interests 10,329 5,781 6,945

Effective tax rate 24.8

% 35.4% 28.3%

In the notes to the financial statements, Pfizer explains that more than one-half of its income from continuing operations is earned outside the United States. This income is taxed at a lower rate than is U.S. income.

4.

2001 2000 1999Net income $7,788 $3,726 $4,952 Earnings per common share—basic $1.25 $0.60 $0.81 Average number of basic shares outstanding 6,230.4 6,210.0 6,113.6

Net income $7,788 $3,726 $4,952 Earnings per common share—diluted $1.22 $0.59 $0.78 Average number of diluted shares outstanding 6,383.6 6,315.3 6,348.7

5.Net income $7,788 $3,726 $4,952 Currency translation adjustment (37) (458) (503)Net unrealized gain (loss) on available-for-sale securities (91) 37 111Minimum pension liability (106 ) (49 ) (20 )Comprehensive income $7,554 $3,256 $4,540

Deciphering 4–3 (Wells Fargo & Company)

1. Financial statements for a financial institution are a lot different than those produced by a manufac-turing firm. Revenues and expenses are partitioned as to those relating to interest and those not re-lating to interest.

2. Net interest income would probably be the term most closely related to the concept of gross profit. In simple terms, a manufacturing business generates profits by selling a product at a price greater than its cost—gross profit. A bank makes money by loaning money at a greater rate than it pays on sav-ings accounts—net interest income.

3.2001 2000 1999

a. Total interest expense 6,741 7,860 5,818Total interest income 19,201 18,725 15,934Ratio 35.1% 42.0% 36.5%

b. Incentive compensation 1,195 846 643Salaries 4,027 3,652 3,307Ratio 29.7% 23.2% 19.4%

c. Employee benefits 960 989 901Salaries 4,027 3,652 3,307Ratio 23.8% 27.1% 27.2%

4. If you think of the relationship between total interest expense and total interest income as the funda-mental measure of operating profitability for a bank, then the performance of Wells Fargo improved substantially in 2001 relative to 2000. In 2001, total interest expense was just 35.1% of total interest income.

Because Wells Fargo’s income statement provides line-item detail about the different components of employee compensation, we can see how big both incentive compensation and fringe benefits are relative to base salaries. The year 2001 seems to have been a good one for Wells Fargo employ-ees; incentive compensation provided an extra 30% over and above salaries. In each year, the cost of employee benefits was around one quarter of the amount of salaries that are paid.

5.Interest expense on deposits 3,553Average amount of deposits 178,413

Average interest rate 2.0%

Interest income on loans 14,461Average loan balance 163,072Average interest rate 8.9%

The cost of the money Wells Fargo gets from its depositors is only 2.0%, which is much less than the 8.9% that Wells Fargo gets from lending this same money. This 6.9% interest rate spread must be enough to cover all of the operating costs of the bank.

6. Price-earnings ratio: 2001—21.8 ($42.99/$1.97)2000—23.1 ($53.90/$2.33)1999—16.7 ($38.31/$2.29)

(Note: These P/E ratios are calculated using the diluted earnings per share numbers. Wells Fargo’s P/E ratio increased substantially between 1999 and 2000. Fundamentally, a company’s P/E ratio in-creases if investors have increased optimism about the chances of future earnings being high rela-tive to current earnings. The P/E ratio fell slightly in 2001.)

Deciphering 4–4 (The Reader's Digest Association, Inc.)

1. In 2001, Reader's Digest generated over 50% of its total operating profit and over 40% of its total revenues from international businesses.

2. Operating profit/Revenues 2001 2000 1999

North America Books and Home En-tertainment

9.9% 12.8% 6.7%

U.S. Magazines 11.8 15.4 17.3International Businesses 10.6 10.3 2.3New Business Development (30.9) (73.2) (14.6)

The U.S. Magazines segment has the highest profitability for each dollar of revenue in 2001 (and in 2000 and 1999 as well).

3. Revenues/Assets 2001 2000 1999

North America Books and Home En-tertainment 1.29 1.32 2.23U.S. Magazines 3.43 3.96 2.02International Businesses 2.28 2.13 2.22New Business Development 0.80 2.50 1.55

The segment with the highest asset turnover, in 2001, is the U.S. Magazines segment.

4. Operating profit/Assets 2001 2000 1999

North America Books and Home En-tertainment 12.7% 16.8% 14.9%U.S. Magazines 40.5 60.9 35.0International Businesses 24.3 22.0 5.0New Business Development (24.7) (182.8) (22.5)

Not surprisingly, the U.S. Magazines segment has the highest return on assets, a combination of high profitability and high efficiency.

5. It would appear that Reader's Digest magazine is the most profitable of the four operating segments. These computations understate the contribution of the magazine to overall company profits. Re-member that the primary method for selling books and home entertainment products is through ad-vertisements in Reader's Digest. Not only is the magazine very profitable itself, but it is also because of the magazine that the other segments of the company are able to be successful.

Deciphering 4–5 (Ford Motor Company)

1. Ford partitions its revenues and expenses into those relating to the Automotive division and those relating to the Financial Services division.

2. 2001 2000 1999

Cost of sales/Sales 98.2% 89.3% 88.1%

Clearly, it is almost mathematically impossible to report an overall profit when cost of sales is equal to 98.2% of sales, as it was in Ford’s Automotive division in 2001.

3. In 2001, sales in Ford’s Automotive division decreased 6.9% compared to 2000. However, both cost of sales and selling, administrative, and other expenses increased during 2001. When the volume of sales activity goes down, but the level of operating expenses does not decline proportionately, one can conclude that some of the operating costs are fixed costs. The 2001 results suggest that many of Ford’s Automotive costs are fixed costs.

4. The Automotive division manufacturers and sells vehicles. In this division, depreciation is a product cost, accounted for as part of manufacturing overhead. Accordingly, the amount of Automotive divi-sion depreciation is included in cost of sales.

5. Negative income tax expense can mean one of three things:

a. The company receives a rebate of taxes paid in the past two years. This is called a net operat-ing loss carryback.

b. If the amount of negative income tax expense is larger than the amount of income taxes paid in the preceding two years, the excess is carried forward to reduce the amount of income taxes paid in future years. This is called a net operating loss carryforward.

c. Some financial accounting expenses are not currently deductible for income tax purposes. One example is a restructuring charge; generally the taxing authorities do not allow a deduction until the restructuring costs are actually spent. In this case, a deferred tax asset is recorded (along with a subtraction from income tax expense) to represent the future benefit that will arise when this expense becomes deductible for income tax purposes.

These three tax-related items are covered at length in Chapter 16.

6. Ford reports the income from the discontinued operation and the loss on the disposal (or spinoff) in separate lines. In the chapter, it was explained that these two items should be added together and shown in one line. Also, Ford reports these amounts net of income taxes. In the chapter, it was ex -plained that the amount of income taxes associated with discontinued operations should be reported in a separate line item. The presentation by Ford conforms with the standard presentation used be-fore the issuance of SFAS No. 144 in August 2001.

7. The year 2001 was a bad year for both the Automotive division and the Financial Services division. Over the 3-year period, cumulative profits in the Financial Services division were greater than cumu-

lative profits in the Automotive division. As discussed in part (3), with the level of fixed costs in the Automotive division, a decline in sales volume can lead to large losses.

8. This question should cause you to realize that Ford makes a great deal of profit from nonautomotive sources. In fact, for the years 19992001, Ford made significantly more profit from financial services. It is also interesting to note that prior to the 1980s, the Financial Services division of Ford was virtu -ally nonexistent.

Deciphering 4–6 (Coca-Cola)

1. In 2001, Coca-Cola’s net income ($3,969 million) was greater than its comprehensive income ($3,858 million).

2. There is a subtraction for foreign currency translation adjustments in the computation of Coca-Cola’s 2001 comprehensive income. This subtraction indicates that the U.S. dollar value of the equity of these foreign subsidiaries declined during the year. Accordingly, during the year, these foreign cur-rencies weakened relative to the U.S. dollar.

3. Coca-Cola’s available-for-sale securities portfolio decreased in value during 2001, as evidenced by the subtraction of an unrealized loss of $29 million in the computation of comprehensive income. (Note: As explained in Chapter 14, the liquidation of a portion of the available-for-sale securities portfolio during the year can make the interpretation of the overall unrealized gain or loss for the year somewhat difficult.)

SAMPLE CPA EXAM QUESTION

The correct answer is c. The operating loss for the discontinued operation was $600,000 in 2005. No dis-posal gains or losses were recognized in 2005. Accordingly, the net amount reported for discontinued op-erations in 2005, after income taxes, is ($360,000) [($600,000) + income tax benefit of $240,000]. Hart’s net gain on the discontinued operation in 2006 was $850,000 ($900,000 disposal gain $50,000 operat-ing loss). After income taxes, the reported amount is $510,000.

Writing Assignment: What are the benefits of a restructuring charge?

The following points might be made in outlining the benefits of recognizing a restructuring charge.

Economic benefitsA big-bath restructuring charge is sometimes evidence that a company has decided to cut its losses and deal decisively with a bad situation, rather than continue to put band-aids on a hopeless case. Thus, the recognition of a big restructuring charge might be part of a campaign to convince investors that a com-pany is committed to changing past unproductive operating practices.

Financial reporting benefitsThe rationale behind an accounting big bath is that the results in the restructuring year are going to be rotten anyway, so why not estimate as many future expenses as possible and recognize them this year? In this way, the reported results in the following years will look great for two reasons: (1) they will be com-pared to the terrible restructuring year and (2) remaining expenses will be small because they were esti-mated and recognized in the restructuring year.

Research Project: Reviewing actual income statements and associated notes.

A sample solution for this research exercise is given below using the 2001 financial statements of McDonald’s.

1. The format of McDonald’s income statement is something between the pure single-step and multi-ple-step statements illustrated in the chapter. Operating revenues and operating expenses are grouped together, like a single-step statement. However, the overall format—with operating income, then interest expense, then income taxes—follows the general multiple-step format.

2.Percentage Increase Percentage Increase from 2000 to 2001 from 1999 to 2000

Total revenues............................................ 4.4% 7.4%Net income................................................. (17.2) 1.5

McDonald’s net income for 2001 actually declined from the 2000 level. Revenue growth slowed substantially in 2001.

3. McDonald’s does not disclose any details about its revenue recognition practice at its company-owned restaurants. This is because these transactions, which are almost exclusively cash sales of food items, are very straightforward. McDonald’s does describe its franchise arrangements in a note to the financial statements. Franchise revenues are composed of initial fees, minimum rentals, and percentage fees based on franchisee sales.

4. During the years 1999, 2000, and 2001, McDonald’s had no below-the-line items.

The Debate: Net income or operating cash flow?

Cash Flow Is King! As any introductory accounting student can attest, the notion of “accrual” is a difficult one to grasp. It

is unlikely that most financial statement users understand exactly what accrual-based income is. On the other hand, everyone understands the difference between cash generated and cash consumed by operating activities.

Bills are paid with cash, not with “accruals.” Financial statement users are most interested in a com-pany’s cash flow.

Operating cash flow is less subject to manipulation by managers trying to massage reported results. Theoretically, a company is worth the discounted present value of the future cash flows to be gener-

ated by the company. Accordingly, performance reporting should focus on cash flows.

Accountants Add Value! Accountants have worked for literally hundreds of years to refine their accrual adjustments in order to

make net income a useful measure of economic activity. Academic research supports the claim that accrual-basis income appears to be the best measure of a company’s economic performance.

Because accrual-basis income is not tied to the timing of cash receipts and cash disbursements, it gives a better overall view of the economic activity of a company. As such, accrual-basis income pro-vides a better foundation with which to forecast future activity, including future cash flows.

Ethical Dilemma

1. If Dwight revises the income statement to achieve the 5% increase in net income and uses biased information to do so, he will be presenting information that has little representational faithfulness. That is, the information will not represent an honest and accurate reflection of the performance of the company.

Another risk to Dwight is that if the company goes public and people invest in the company based on the financial statements produced by Dwight, those investors may have recourse to the company and Dwight if they should lose money.

If Dwight were to give in this time and revise the income statement to meet the requested “goals” of management, Dwight may find himself being asked to revise the income statement each period. This may not be a one-time issue.

2. If Dwight does not revise the financial statements and cannot convince the members of the board of directors of the validity of his reasons for not doing so, he may find himself out of a job. What Dwight needs to consider is how attractive it will be to continue to work in an organization where he is ex -pected to manage earnings.

Cumulative Spreadsheet Analysis

See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual.

Internet Search

Both the Fortune and Forbes lists for 2002 (using 2001 data) indicated that the company with the highest profit was ExxonMobil. Fortune reported the amount of ExxonMobil profit for 2001 to be $15,320 million; Forbes reported 2001 ExxonMobil profit to be $15,105 million. The 2001 income statement of ExxonMobil indicates the following:

Income before extraordinary item $15,105Extraordinary gain, net of tax 215

Net income $15,320

Apparently, Fortune uses bottom-line net income in doing its profit ranking, whereas Forbes excludes below-the-line items in doing its ranking. The procedure used by Forbes is the better one because the whole point of reporting items below the line is that they are not indicative of the company’s core operat -ing performance for the year.