Spiceland SM 7eCh04

7/25/2019 Spiceland SM 7eCh04

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The McGraw-Hill Companies, Inc., 2007

Solutions Manual, Vol.1, Chapter 4 4-1

Question 4-1The income statement is a change statement that reports transactions revenues, expenses

gains and losses that cause owners equity to change during a specified reporting period.

Question 4-2Comprehensive income is the total change in equity for a reporting period other than from

transactions with owners. Reporting comprehensive income can be accomplished with a separatestatement or by including the information in either the income statement or the statement of changes

in shareholders equity.

Question 4-3Income from continuing operations includes the revenue, expense, gain and loss transactions

that will probably continue in future periods. It is important to segregate the income effects of theseitems because they are the most important transactions in terms of predicting future cash flows.

Question 4-4Operating income includes revenues and expenses that are directly related to the principa

revenue generating activities of the company. Nonoperating income includes items that are nodirectly related to these activities.

Question 4-5The single-step format first lists all revenues and gains included in income from continuing

operations to arrive at total revenues and gains. All expenses and losses are then grouped andsubtotaled, subtracted from revenues and gains to arrive at income from continuing operations. Themultiple-stepformat reports a series (multiple) of intermediate totals such as gross profit, operatingincome, and income before taxes. Very often income statements adopt variations of these formatsfalling somewhere in between the two extremes.

Question 4-6The term earnings quality refers to the ability of reported earnings (income) to predict a

companys future earnings. After all, an income statement simply reports on events that already haveoccurred. The relevance of any historical-based financial statement hinges on its predictive value.

Question 4-7Restructuring costs include costs associated with shutdown or relocation of facilities or

downsizing of operations. They are reported as an operating expense in the income statement.

Chapter 4 The Income Statement and Statement of CashFlows

QUESTIONS FOR REVIEW OF KEY TOPICS
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4-2 Intermediate Accounting, 4/e

Answers to Questions (continued)

Question 4-8The process of intraperiod tax allocation matches tax expense or tax benefit with each major

component of income, specifically continuing operations and any item reported below continuing

operations. The process is necessary to achieve the desired result of separating the total incomeeffects of continuing operations from the two separately reported items - discontinued operations andextraordinary items, and also to show the after-taxeffect of each of those two components.

Question 4-9A component of an entity comprises operations and cash flows that can be clearly

distinguished, operationally and for financial reporting purposes.The net-of-tax income effects of a discontinued operation must be disclosed separately in the

income statement, below income from continuing operations. The income effects include income(loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosedeither on the face of the statement or in a disclosure note. If the component is held for sale but not

sold by the end of the reporting period, the income effects will include income (loss) from operationsand an impairment loss if the fair value less costs to sell is less than the book value of thecomponents assets. The income (loss) from operations of the component is reported separately indiscontinued operations on prior income statements presented for comparative purposes.

Question 4-10Extraordinary itemsare material gains and losses that are both unusual in nature and infrequent

in occurrence, taking into account the environment in which the entity operates.

Question 4-11Extraordinary gains and losses are presented, net of tax, in the income statement below

discontinued operations, if any.


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Answers to Questions (continued)

Question 4-12GAAP permit alternative treatments for similar transactions. Common examples are the choice

among FIFO, LIFO, and average cost for the measurement of inventory and the choice amongalternative revenue recognition methods. A change in accounting principle occurs when a companychanges from one generally accepted treatment to another.

In general, we report voluntary changes in accounting principles retrospectively. This meansrevising all previous periods financial statements as if the new method were used in those periods.In other words, for each year in the comparative statements reported, we revise the balance of eachaccount affected. Specifically, we make those statements appear as if the newly adopted accountingmethod had been applied all along. Also, if retained earnings is one of the accounts whose balancerequires adjustment (and it usually is), we revise the beginning balance of retained earnings for theearliest period reported in the comparative statements of shareholders equity (or statements ofretained earnings if theyre presented instead). Then we create a journal entry to adjust all account

balances affected as of the date of the change. In the first set of financial statements after thechange, a disclosure note would describe the change and justify the new method as preferable. It alsowould describe the effects of the change on all items affected, including the fact that the retainedearnings balance was revised in the statement of shareholders equity.

An exception is a change in depreciation, amortization, or depletion method. These changesare accounted for as a change in estimate, rather than as a change in accounting principle. Changesin estimates are accounted for prospectively. The remaining book value is depreciated, amortized, ordepleted, using the new method, over the remaining useful life.

Question 4-13Earnings per share(EPS) is the amount of income achieved during a period for each share of

common stock outstanding. If there are different components of income reported below continuingoperations, their effects on earnings per share must be disclosed. If a period contains discontinuedoperations and extraordinary items, EPS data must be reported separately for income fromcontinuing operations and net income. Per share amounts for discontinued operations andextraordinary items would be disclosed on the face of the income statement.

Question 4-14A change in accounting estimate is accounted for in the year of the change and in subsequent

periods; prior years financial statements are not restated. A disclosure note should justify that thechange is preferable and describe the effect of a change on any financial statement line items and pershare amounts affected for all periods reported.


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Answers to Questions (concluded)

Question 4-15Prior period adjustments are accounted for by restating prior years financial statements when

those statements are presented again for comparison purposes. The beginning of period retainedearnings is increased or decreased on the statement of shareholders equity (or the statement ofretained earnings) in the year the error is discovered.

Question 4-16The purpose of the statement of cash flows is to provide information about the cash receipts

and cash disbursements of an enterprise during a period. Similar to the income statement, it is achangestatement, summarizing the transactions that caused cash to change during a particular periodof time.

Question 4-17

The three categories of cash flows reported on the statement of cash flows are:1. Operating activities Inflows and outflows of cash related to the transactions entering

into the determination of net income from operations.2. Investing activities Involve the acquisition and sale of (1) long-term assets used in the

business and (2) nonoperating investment assets.3. Financing activities Involve cash inflows and outflows from transactions with creditors

and owners.

Question 4-18Noncash investing and financing activities are transactions that do not increase or decrease

cash but are important investing and financing activities. An example would be the acquisition of

property, plant and equipment (an investing activity) by issuing either long-term debt or equitysecurities (a financing activity). These activities are reported either in a separate schedule or in anote.

Question 4-19The direct method of reporting cash flows from operating activities presents the cash effect of

each operating activity directly on the statement of cash flows. The indirect method of reportingcash flows from operating activities is derived indirectly, by starting with reported net income andadding and subtracting items to convert that amount to a cash basis.


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Brief Exercise 4-1

OREILLY BEVERAGE COMPANYStatement of Comprehensive Income

For the Year Ended December 31, 2006

Net income ........................................................ $650,000Other comprehensive income (loss):

Unrealized gains on investment securitiesnet of tax ...................................................... $ 24,000

Deferred loss on derivatives, net of tax ........... (36,000)Total other comprehensive loss ......................... (12,000)Comprehensive income ..................................... $638,000

BRIEF EXERCISES


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Brief Exercise 4-2

PACIFIC SCIENTIFIC CORPORATIONIncome StatementFor the Year Ended December 31, 2006

($ in millions)

Revenues and gains:Sales ............................................................... $2,106Gain on sale of investments ............................ 45

Total revenues and gains ............................. 2,151

Expenses and losses:

Cost of goods sold .......................................... $1,240Selling ............................................................. 126General and administrative .............................. 105Interest............................................................. 35Income tax expense* ....................................... 258

Total expenses and losses ............................ 1,764Net income ........................................................ $ 387

*$2,151 (1,240 + 126 + 105 + 35) = $645 x 40% = $258

Brief Exercise 4-3(a) Sales revenue $2,106

Less: Cost of goods sold (1,240)

Gross profit 866Less: Selling expenses (126)

General and administrative expenses (105)Operating income $ 635

(b) Gain on sale of investments 45Interest expense (35)

Nonoperating income $10


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Brief Exercise 4-4

PACIFIC SCIENTIFIC CORPORATIONIncome Statement

For the Year Ended December 31, 2006($ in millions)

Sales revenue ..................................................... $2,106Cost of goods sold ............................................. 1,240Gross profit ....................................................... 866

Operating expenses:

Selling ............................................................. $126General and administrative .............................. 105

Total operating expenses ............................. 231Operating income .............................................. 635

Other income (expense):Gain on sale of investments ............................ 45Interest expense .............................................. (35)

Total other income, net ................................ 10

Income before income taxes ............................. 645Income tax expense* ......................................... 258

Net income ........................................................ $ 387

*$645 x 40%


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Brief Exercise 4-5(a) Sales revenue $300,000

Less: Cost of goods sold (160,000)

General and administrative expenses (40,000)Restructuring costs (50,000)Selling expenses (25,000)

Operating income $ 25,000

(b) Operating income $25,000Add: Interest revenue 4,000Deduct: Loss on sale of investments (22,000)Income before income taxes and

Extraordinary item 7,000

Income tax expense (40%) (2,800)Income before extraordinary item $ 4,200

(c) Income before extraordinary item $ 4,200Extraordinary item:Loss from flood damage, net of $20,000

tax benefit (30,000)Net loss (25,800)


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Brief Exercise 4-6

WHITE AND SONS, INC.Partial Income Statement


Income before income taxes and extraordinary item.......... $ 850,000Income tax expense* ........................................................ 340,000Income before extraordinary item ..................................... 510,000Extraordinary item:

Loss from earthquake, net of $160,000 tax benefit ......... (240,000)Net income ........................................................................ $ 270,000

Earnings per share:Income before extraordinary item...................................... $ 5.10Loss from earthquake ....................................................... (2.40)

Net income ....................................................................... $ 2.70

*$850,000 x 40%

Note: Restructuring costs, interest revenue, and loss on sale of investments are

included in income before income taxes and extraordinary item.


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Brief Exercise 4-7

CALIFORNIA MICROTECH CORPORATIONPartial Income Statement


Income from continuing operations before income taxes... $ 5,800,000

Income tax expense* ......................................................... 1,740,000Income from continuing operations .................................. $ 4,060,000Discontinued operations:

Loss from operationsof discontinued component(including gain on disposal of $2,000,000)** ......................... (1,600,000)

Income tax benefit .......................................................... 480,000Loss on discontinued operations ..................................... (1,120,000)Net income ........................................................................ $ 2,940,000

* $5,800,000 x 30%**Loss from operations of discontinued component:

Gain on sale of assets $ 2,000,000 ($10 million less $8 million)Operating loss (3,600,000)

Total before-tax loss $(1,600,000)


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Brief Exercise 4-8





Loss from operationsof discontinued component** ...... (3,600,000)Income tax benefit .......................................................... 1,080,000

Loss on discontinued operations ..................................... (2,520,000)Net income ........................................................................ $ 1,540,000

* $5,800,000 x 30%**Includes only the operating loss. There is no impairment loss.


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Brief Exercise 4-9





Loss from operationsof discontinued component(including impairment loss of $1,000,000)** ......................... (4,600,000)

Income tax benefit .......................................................... 1,380,000Loss on discontinued operations ..................................... (3,220,000)Net income ........................................................................ $ 840,000

*$5,800,000 x 30%**Loss from operations of discontinued component:

Impairment loss ($8 million book value less$7 million net fair value) $(1,000,000)

Operating loss (3,600,000)Total before-tax loss $(4,600,000)


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Brief Exercise 4-10

The change in inventory method is a change in accounting principle. The

depreciation method change is considered to be a change in accounting estimate that isachieved by a change in accounting principle and is accounted for prospectively,exactly as we would account for any other change in estimate. The inventory methodchange, however, is accounted for by retrospectively recasting prior years financialstatements presented with the current year for comparative purposes, applying the newinventory method (FIFO in this case) in those years.

Brief Exercise 4-11

This is a change in accounting estimate.

When an estimate is revised as new information comes to light, accounting forthe change in estimate is quite straightforward. We do not restate prior yearsfinancial statements to reflect the new estimate. Instead, we merely incorporate thenew estimate in any related accounting determinations from there on. If the after-tax

income effect of the change in estimate is material, the effect on net income andearnings per share must be disclosed in a note, along with the justification for the

change. Depreciation for 2006 is $25,000:

$300,000 Cost$ 50,000 Old annual depreciation ($300,000 6 years)x 2 years 100,000 Depreciation to date(2004-2005)

200,000 Book value_ 8 yrs. Estimated remaining life(10 years - 2 years)$ 25,000 New annual depreciation


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Brief Exercise 4-12

Cash Flows from Operating Activities:

Collections from customers $ 660,000Interest on note receivable 12,000Interest on note payable (18,000)Payment of operating expenses (440,000)

Net cash flows from operating activities $214,000

Only these four cash flow transactions relate to operating activities. The others areinvesting and financing activities.

Brief Exercise 4-13

Cash Flows from Investing Activities:

Sale of land $ 40,000Purchase of equipment (120,000)

Net cash flows from investing activities $(80,000)

Cash Flows from Financing Activities:

Proceeds from note payable collection $100,000

Issuance of common stock 200,000Payment of dividends (30,000)

Net cash flows from financing activities 270,000


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Brief Exercise 4-14

Cash Flows from Operating Activities:

Net income $45,000Adjustments for noncash effects:Depreciation expense 80,000Increase in prepaid rent (60,000)Increase in salaries payable 15,000Increase in income taxes payable 12,000

Net cash inflows from operating activities $92,000


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Exercise 4-1

Requirement 1

THE MASSOUD CONSULTING GROUPStatement of Income and Comprehensive Income (in part)


Net income ........................................................ $1,354,000Other comprehensive income (loss):

Foreign currency translation gain, net of tax ... $168,000

Unrealized losses on investment securities,net of tax ...................................................... (56,000)

Total other comprehensive income .................... 112,000Comprehensive income ..................................... $1,466,000

Requirement 2

THE MASSOUD CONSULTING GROUP

Statement of Comprehensive IncomeFor the Year Ended December 31, 2006

Net income ........................................................ $1,354,000Other comprehensive income (loss):

Foreign currency translation gain, net of tax ... $168,000Unrealized losses on investment securities

net of tax ...................................................... (56,000)Total other comprehensive income .................... 112,000Comprehensive income ..................................... $1,466,000

EXERCISES


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Exercise 4-2

Requirement 1

GREEN STAR CORPORATIONIncome Statement


Revenues and gains:Sales ............................................................... $1,300,000

Interest ............................................................ 30,000

Gain on sale of equipment .............................. 50,000Total revenues and gains ............................. 1,380,000

Expenses and losses:Cost of goods sold .......................................... $720,000Salaries ............................................................ 160,000Depreciation .................................................... 50,000Interest............................................................. 40,000Rent ................................................................. 25,000Income tax ...................................................... 130,000

Total expenses and losses ............................ 1,125,000Net income ........................................................ $ 255,000

Earnings per share ............................................. $2.55


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Exercise 4-2 (concluded)

Requirement 2

GREEN STAR CORPORATIONIncome Statement


Sales revenue ..................................................... $1,300,000Cost of goods sold ............................................. 720,000Gross profit ....................................................... 580,000

Operating expenses:

Salaries ............................................................ $160,000Depreciation .................................................... 50,000Rent ................................................................ 25,000

Total operating expenses ............................. 235,000Operating income .............................................. 345,000

Other income (expense):Interest revenue ............................................... 30,000Gain on sale of equipment .............................. 50,000Interest expense .............................................. (40,000)

Total other income, net ................................ 40,000Income before income taxes ............................. 385,000Income tax expense ........................................... 130,000

Net income ........................................................ $ 255,000

Earnings per share ............................................. $2.55


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Exercise 4-3

Requirement 1

GENERAL LIGHTING CORPORATIONIncome Statement


Revenues and gains:Sales ............................................................... $2,350,000Rental revenue ................................................ 80,000

Total revenues and gains ............................. 2,430,000

Expenses and losses:Cost of goods sold .......................................... $1,200,300Salaries ........................................................... 300,000Depreciation .................................................... 100,000Interest............................................................. 90,000Rent ................................................................ 50,000Loss on sale of equipment ............................... 22,500Loss from inventory write-down ..................... 200,000Income tax expense *....................................... 186,880

Total expenses and losses ............................ 2,149,680Income before extraordinary item ......................

Extraordinary item:Loss from flood damage (net of $48,000 tax benefit)

Net income ........................................................

280,320

(72,000)$ 208,320

Earnings per share:Income before extraordinary item ......................Extraordinary loss .............................................

Net income ........................................................

$ .93(.24)

$ .69

* 40% x $467,200


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Requirement 2

GENERAL LIGHTING CORPORATION

Income StatementFor the Year Ended December 31, 2006

Sales revenue ..................................................... $2,350,000Cost of goods sold ............................................. 1,200,300Gross profit ....................................................... 1,149,700

Operating expenses:Salaries ........................................................... $300,000Depreciation ................................................... 100,000

Rent ................................................................ 50,000Loss from inventory write-down ..................... 200,000

Total operating expenses ............................. 650,000

Operating income .............................................. 499,700

Other income (expense):Rental revenue ................................................ 80,000Loss on sale of equipment ............................... (22,500)Interest expense .............................................. (90,000)

Total other income (expense), net ................ (32,500)

Income before taxes and extraordinary item ...... 467,200Income tax expense * ......................................... 186,880Income before extraordinary item ......................Extraordinary item:Loss from flood damage (net of $48,000 tax benefit)

Net income ........................................................

280,320

(72,000)$ 208,320

Earnings per share:

Income before extraordinary item ......................

Extraordinary loss .............................................Net income ........................................................

$ .93

(.24)$ .69

* 40% x $467,200


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Exercise 4-4

LINDOR CORPORATION

Statement of Income and Comprehensive IncomeFor the Year Ended December 31, 2006

Sales revenue ................................................................ $2,300,000Cost of goods sold ......................................................... 1,400,000Gross profit ................................................................... 900,000

Operating expenses:Selling and administrative........................................... 420,000

Operating income .......................................................... 480,000

Other income (expense):Interest expense ............................................................. (40,000)Income before income taxes and extraordinary item ...... 440,000Income tax expense * ..................................................... 132,000Income before extraordinary item ..................................Extraordinary item:Gain on early debt extinguishment (net of $120,000

tax expense) ...............................................................Net incomeOther comprehensive income:

Unrealized holding gains on investment securities,net of tax .................................................................

Comprehensive income .................................................

308,000

280,000588,000

56,000

$644,000

Earnings per share:Income before extraordinary item ..................................Extraordinary gain .........................................................Net income ....................................................................

$ 0.310.28

$ 0.59

* 30% x $440,000


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Exercise 4-5

AXEL CORPORATION


Sales revenue ................................................................. $ 592,000Cost of goods sold ......................................................... 325,000Gross profit ................................................................... 267,000

Operating expenses:Selling ....................................................................... $67,000Administrative ........................................................... 87,000Restructuring costs ..................................................... 55,000

Total operating expenses .......................................... 209,000Operating income .......................................................... 58,000

Other income (expense):Interest and dividends ................................................. 32,000Interest expense ..........................................................Total other income, net ...............................................

(26,000)6,000

Income before income taxes and extraordinary item ..... 64,000Income tax expense* ..................................................... 25,600Income before extraordinary item ..................................Extraordinary item:

Gain on early debt extinguishment (net of $34,400tax expense)................................................................

Net income ....................................................................

38,400

51,600$ 90,000

Earnings per share:Income before extraordinary item ..................................Extraordinary gain .........................................................Net income ....................................................................

$ .38.52

$0.90

* 40% x $64,000


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Exercise 4-6

CHANCE COMPANYPartial Income Statement


Income from continuing operations .................................. $ 350,000Discontinued operations:

Loss from operationsof discontinued component(including loss on disposal of $400,000)* .............................. (530,000)

Income tax benefit .......................................................... 212,000Loss on discontinued operations ..................................... (318,000)

Net income ........................................................................ $ 32,000

Earnings per share:Income from continuing operations .................................. $ 3.50Loss from discontinued operations ................................... (3.18)

Net income ....................................................................... $ .32

* Loss on discontinued operations:

Loss on sale of assets $(400,000)Operating loss (130,000)

Total before-tax loss (530,000)

Less: Income tax benefit (40%) 212,000Net-of-tax loss $(318,000)


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Exercise 4-7

ESQUIRE COMIC BOOK COMPANYPartial Income StatementFor the Year Ended December 31, 2006

Income from continuing operations * ................................. $ 552,000

Discontinued operations:Income from operations of discontinued component

(including loss on disposal of $350,000) ................................. 150,000Income tax expense ......................................................... 60,000

Income on discontinued operations .................................. 90,000Net income .......................................................................... 642,000

* Income from continuing operations:

Income before considering additional items $1,000,000Decrease in income due to restructuring costs (80,000)

Before-tax income from continuing operations 920,000Income tax expense (40%) (368,000)

Income from continuing operations $ 552,000


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Exercise 4-8

Requirement 1

KANDON ENTERPRISES, INC.Partial Income Statement


Income from continuing operations .................................. $ 400,000

Discontinued operations:Loss from operations of discontinued component

(including impairment loss of $50,000) *............................. (190,000)

Income tax benefit .......................................................... 76,000

Loss on discontinued operations ..................................... (114,000)Net income ....................................................................... $ 286,000

*Loss on discontinued operations:

Operating loss $(140,000)Impairment loss ($250,000 - 200,000) (50,000)

Net before-tax loss (190,000)Income tax benefit (40%) 76,000

Net after-tax loss on discontinued operations $(114,000)

Requirement 2

KANDON ENTERPRISES, INC.Partial Income Statement


Income from continuing operations .................................. $ 400,000

Discontinued operations:Loss from operations of discontinued component * ........ (140,000)Income tax benefit ......................................................... 56,000Loss on discontinued operations ..................................... (84,000)

Net income ....................................................................... $ 316,000

*Includes only the operating loss during the year. There is no impairment loss.


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Exercise 4-9

Pretax income from continuing operations $14,000,000

Income tax expense (5,600,000)Income from continuing operations 8,400,000Less: Net income 7,200,000Loss from discontinued operations $1,200,000

$1,200,000 60%* = $2,000,000 = before tax loss from discontinued

operations.

*1-tax rate of 40% = 60%

Pretax income of division $4,000,000Add: Net loss from discontinued operations 2,000,000

Impairment loss $6,000,000

Fair value of divisions assets $11,000,000Plus impairment loss 6,000,000Book value of divisions assets $17,000,000


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Exercise 4-10

Requirement 1

This is a change in accounting estimate.

Requirement 2

When an estimate is revised as new information comes to light, accounting forthe change in estimate is quite straightforward. We do not restate prior yearsfinancial statements to reflect the new estimate. Instead, we merely incorporate thenew estimate in any related accounting determinations from there on. If the after-taxincome effect of the change in estimate is material, the effect on net income andearnings per share must be disclosed in a note, along with the justification for thechange.

Requirement 3

$800,000 Cost$160,000 Old annual depreciation ($800,000 5 years)x 2 years 320,000 Depreciation to date(2004-2005)

480,000 Book value_ 6 yrs. Estimated remaining life(8 years - 2 years)$ 80,000 New annual depreciation


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Exercise 4-11

Requirement 1

In general, we report voluntary changes in accounting principles retrospectively.

However, a change in depreciation method is considered a change in accountingestimate resulting from a change in accounting principle. In other words, a change inthe depreciation method reflects a change in the (a) estimated future benefits from theasset, (b) the pattern of receiving those benefits, or (c) the companys knowledgeabout those benefits, and therefore the two events should be reported the same way.Accordingly, Canliss reports the change prospectively; previous financial statementsare not revised. Instead, the company simply employs the straight-line method fromnow on. The undepreciated cost remaining at the time of the change would bedepreciated using the straight-line method over the remaining useful life. A disclosure

note should justify that the change is preferable and describe the effect of the changeon any financial statement line items and per share amounts affected for all periodsreported.

Requirement 2

Assets cost $800,000

Accumulated depreciation to date ($320,000 + 192,000) (512,000)

To be depreciated over remaining 3 years $288,000

2006 straight-line depreciation: $288,000 3 years = $96,000

Adjusting entry:

Depreciation expense (calculated above)..................... 96,000Accumulated depreciation ..................................... 96,000

Exercise 4-12Earnings per share:

Income from continuing operations $5.00Loss from discontinued operations (1.60)Extraordinary gain 2.20

Net income $5.60


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Exercise 4-131. d2. d

Exercise 4-141. b Purchase of equipment for cash.2. a Payment of employee salaries.3. a Collection of cash from customers.4. c Cash proceeds from a note payable.5. b Purchase of common stock of another corporation for cash.6. c Issuance of common stock for cash.7. b Sale of machinery for cash.8. a Payment of interest on note payable.9. d Issuance of bonds payable in exchange for land and building.

10. c Payment of cash dividends to shareholders.11. c Payment of principal on note payable.


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Exercise 4-15Bluebonnet Bakers

Statement of Cash Flows

For the Year Ended December 31, 2006Cash flows from operating activities:

Collections from customers $ 380,000Interest on note receivable 6,000Purchase of inventory (160,000)Interest on note payable (5,000)Payment of salaries (90,000)Net cash flows from operating activities $131,000

Cash flows from investing activities:Collection of note receivable 50,000Sale of investments 30,000Purchase of equipment (85,000)

Net cash flows from investing activities (5,000)

Cash flows from financing activities:Proceeds from note payable 100,000Payment of note payable (25,000)Payment of dividends (20,000)

Net cash flows from financing activities 55,000

Net increase in cash 181,000

Cash and cash equivalents, January 1 17,000

Cash and cash equivalents, December 31 $ 198,000


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Exercise 4-16

Requirement 1

Financing Investing Operating1. $300,000

2. ! $(10,000)

3. !4. !5. $ (5,000)6. (6,000)7. (70,000)8. 55,000

9. !__________ __________ __________

$300,000 $(10,000) $(26,000) = $264,000


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Requirement 2

Wainwright Corporation

Statement of Cash FlowsFor the Month Ended March 31, 2006

Cash flows from operating activities:

Collections from customers $ 55,000Payment of rent (5,000)Payment of one-year insurance premium (6,000)Payment to suppliers of merchandise for sale (70,000)Net cash flows from operating activities $ (26,000)

Cash flows from investing activities:Purchase of equipment (10,000)Net cash flows from investing activities (10,000)

Cash flows from financing activities:Issuance of common stock 300,000Net cash flows from financing activities 300,000

Net increase in cash 264,000Cash and cash equivalents, March 1 40,000Cash and cash equivalents, March 31 $ 304,000

Noncash investing and financing activities:Acquired $40,000 of equipment by paying cash and issuing a note as follows:

Cost of equipment $40,000Cash paid 10,000Note issued $30,000


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Exercise 4-171. c2. d

3.

b


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Exercise 4-18Tiger Enterprises


For the Year Ended December 31, 2006($ in thousands)

Cash flows from operating activities:Net income $ 900Adjustments for noncash effects:

Depreciation expense 240Decrease in accounts receivable 80Increase in inventory (40)Increase in prepaid insurance (30)

Decrease in accounts payable (60)Decrease in administrative & other payables (100)

Increase in income taxes payable 50Net cash flows from operating activities $1,040

Cash flows from investing activities:Purchase of plant and equipment (300)

Cash flows from financing activities:Proceeds from issuance of common stock 100

Proceeds from note payable 200Payment of dividends (1) (940)

Net cash flows from financing activities (640)

Net increase in cash 100

Cash, January 1 200Cash, December 31 $ 300

(1)

Retained earnings, beginning $540

+ Net income 900- Dividends x x = $940Retained earnings, ending $500


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Exercise 4-19The T-account analysis of the transactions related to operating cash flows is

shown below. To derive the cash flows, the beginning and ending balances in the

related assets and liabilities are inserted, together with the revenue and expenseamounts from the income statements. In each balance sheet account, the remaining(plug) figure is the other half of the cash increases or decreases.

Cash Flows (Operating)

(a.) 7,080 (b.) 130

(c.) 3,460

(d.) 1,900

(e.) 550

Sales Revenue Accounts Receivable

1/1 830 (a.) 7,080

7,000 7,00012/31 750

Prepaid Insurance Insurance Expense

1/1 20

(b.) 130 100 100

12/31 50

Accounts Payable Inventory Cost of Goods Sold

(c.) 3,460 1/1 360 1/1 600 3,360 3,360

3,400 3,400

12/31 300 12/31 640

Admin. & Other Payables Admin. & Other Expense

(d.) 1,900 1/1 400

1,800 1,800

12/31 300

Income Taxes Payable Income Tax Expense

(e.) 550 1/1 150

600 600

12/31 200

Based on the information in the T-accounts above, the operating activities section

of the SCF for Tiger Enterprises would be as shown below.


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Tiger Enterprises

Statement of Cash FlowsFor the Year Ended December 31, 2006

($ in thousands)

Cash flows from operating activities:Collections from customers $ 7,080Prepayment of insurance (130)Payment to inventory suppliers (3,460)Payment for administrative & other exp. (1,900)Payment of income taxes (550)

Net cash flows from operating activities $ 1,040

Exercise 4-20

List A List B

f 1. Intraperiod tax allocation a. Unusual, infrequent, and material gains andlosses.

g 2. Comprehensive income b. Starts with net income and works backwards toconvert to cash.

a 3. Extraordinary items c. Reports the cash effects of each operatingactivity directly on the statement.

l 4. Operating income d. Correction of a material error of a prior period.k 5. An operation (according to SFAS 144) e. Related to the external financing of the company.

j 6. Earnings per share f. Associates tax with income statement item.d 7. Prior period adjustment g. Total nonowner change in equity.e 8. Financing activities h. Related to the transactions entering into the

determination of net income.h 9. Operating activities (SCF) i. Related to the acquisition and disposition of

long-term assets.i 10. Investing activities j. Required disclosure for publicly traded

corporation.c 11. Direct method k. A component of an entity.b 12. Indirect method l. Directly related to principal revenue-generating

activities.


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Exercise 4-21

1. c. The operating section of a retailers income statement includes all revenues andcosts necessary for the operation of the retail establishment, e.g., sales, cost ofgoods sold, administrative expenses, and selling expenses.

2.

d. Discontinued operations and extraordinary gains and losses are shownseparately in the income statement, below income from continuing operations.The cumulative effect of a change in accounting principle is accounted for byretrospectively revising prior years financial statements.

3. a. Extraordinary items should be presented net of tax after income fromoperations.


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Problem 4-1

DUKE COMPANYStatement of Income and Comprehensive Income


Sales revenue ................................................................ $15,000,000Cost of goods sold ........................................................ 9,000,000Gross profit ................................................................... 6,000,000

Operating expenses:General and administrative ......................................... $1,000,000Selling ...................................................................... 500,000

Restructuring costs ..................................................... 300,000Loss from write-down of obsolete inventory 400,000Total operating expenses ......................................... 2,200,000

Operating income ......................................................... 3,800,000

Other income (expense):Interest expense ......................................................... (700,000)

Income before income taxes and extraordinary item ...... 3,100,000Income tax expense ....................................................... 1,240,000Income before extraordinary item ................................. 1,860,000Extraordinary item:Loss from expropriation of overseas plant (net

of $1,200,000 tax benefit) .......................................... (1,800,000)Net Income .................................................................... 60,000Other comprehensive income (loss):

Foreign currency translation adjustment loss, net of tax (120,000)Unrealized gains on investment securities, net of tax 108,000

Total other comprehensive loss (12,000)Comprehensive income $ 48,000

Notes:1. The restructuring costs and the loss from write-down of inventory are not extraordinary items.2. The depreciation expense error is a prior period adjustment and is not reported in the income

statement.

PROBLEMS


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Problem 4-2

REED COMPANYComparative Income Statements

For the Years Ended December 31

2006 2005

Sales revenue ......................................................[1] $4,000,000 [6] $3,000,000Cost of goods sold ...............................................[2] 2,570,000 [7] 1,680,000Gross profit ......................................................... 1,430,000 1,320,000

Operating expenses:Administrative ..................................................[3] 750,000 [8] 635,000Selling ..............................................................[4] 340,000 [9] 282,000Loss from fire damage ....................................... 50,000 - -Loss from write-down of obsolete inventory ...... 35,000 - -

Total operating expenses ............................... 1,175,000 917,000Operating income ................................................ 255,000 403,000

Other income (expense):Interest revenue .................................................. 150,000 140,000Interest expense ................................................. (200,000) (200,000)

Total other expenses (net) .............................. (50,000) (60,000)Income from continuing operations before

income taxes and extraordinary item............... 205,000 343,000Income tax expense ............................................. 82,000 137,200Income from continuing operations before

extraordinary item............................................ 123,000 205,800

Discontinued operations:Income (loss) from operations of discontinuedcomponent (including loss on disposal of$50,000 in 2006) ............................................. (10,000) 110,000

Income tax benefit(expense) ............................... 4,000 (44,000)Income (loss) on discontinued operations ......... [5] (6,000) 66,000

Income before extraordinary item ........................ 117,000 271,800Extraordinary item:Loss from early extinguishment of debt (net

of $40,000 tax benefit) .................................. (60,000) - -Net income .......................................................... $ 57,000 $ 271,800

Earnings per share:Income from continuing operations before

extraordinary item............................................ $ .41 $ .69Discontinued operations ..................................... (.02) .22Extraordinary item ............................................. (.20) - -

Net income .......................................................... $ .19 $ .91


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Problem 4-2 (concluded)

[1] $4,400,000 - 400,000

[2] $2,860,000 - 290,000

[3] $800,000 - 50,000

[4] $360,000 - 20,000

[5] Loss in 2006:Operating income $ 40,000Loss on sale of assets (50,000)Loss before tax benefit (10,000)Tax benefit (40% x $10,000) 4,000

Loss on discontinued operations, net of tax benefit $ (6,000)

[6] $3,500,000 - 500,000 (sales from discontinued operation)

[7] $2,000,000 - 320,000 (cost of goods sold from discontinued operation)

[8] $675,000 - 40,000 (administrative expenses from discontinued operations)

[9] $312,000 - 30,000 (selling expenses from discontinued operations)


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Problem 4-3

Requirement 1

JACKSON HOLDING COMPANY

Comparative Income Statements (in part)For the Years Ended December 31

2006 2005

Income from continuing operations beforeincome taxes [1] ......................................... $3,000,000 $1,300,000

Income tax expense ........................................ 1,200,000 520,000Income from continuing operations ................ 1,800,000 780,000Discontinued operations:Income from operations of discontinued

component (including gain on disposal of$600,000 in 2006)[2]....................................... 200,000 (300,000)

Income tax expense (benefit) ........................ 80,000 120,000Income (loss) on discontinued operations ..... 120,000 (180,000)

Net Income ..................................................... $1,920,000 $ 600,000

[1] Income from continuing operations before income taxes:

2006 2005Unadjusted $2,600,000 $1,000,000Add: Loss from discontinued operation 400,000 300,000Adjusted $3,000,000 $1,300,000

[2] Income from discontinued operations:

2006 2005Operating loss $(400,000) $(300,000)

Gain on disposal 600,000 -Total $ 200,000 $(300,000)


Requirement 2

The 2006 income from discontinued operations would include only the operatingloss of $400,000. Since no impairment loss is indicated ($5,000,000 4,400,000 =


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$600,000 anticipated gain), none is included. The anticipated gain on disposal is notrecognized until it is realized, presumably in the following year.

Requirement 3

The 2006 income from discontinued operations would include the operating loss

of $400,000 as well as an impairment loss of $500,000 ($4,400,000 book value ofassets less $3,900,000 fair value).


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Problem 4-4

Requirement 1

MICRON CORPORATIONPartial Income Statement


Income from continuing operations beforeincome taxes and extraordinary item ....... [1]$1,300,000

Income tax expense ................................... 390,000

Income from continuing operations ........... 910,000

Discontinued operations:Loss from operations of discontinued

component (including loss on disposal of$300,000) ............................................... $ (140,000)

Income tax benefit .................................. (42,000)

Loss on discontinued operations .............. [2] (98,000)

Income before extraordinary item .............. 812,000

Extraordinary item:Gain from early extinguishment of debt

(net of $120,000 tax expense).................... 280,000

Net Income ................................................ $1,092,000

[1] Income from continuing operations before taxes:Unadjusted $1,200,000Add: Gain from sale of factory 100,000Adjusted $1,300,000

[2] Loss on discontinued operations:Operating income $ 160,000Deduct: Loss on sale of assets (300,000)Loss before tax (140,000)Tax benefit (30% x $140,000) 42,000

Loss on discontinued operations $ (98,000)

Requirement 2

These events will not, or are unlikely to occur again in the near future. Bysegregating them, users are better able topredict future cash flows.


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Problem 4-5

Requirement 1

Diversified Portfolio Corporation



Collections from customers (1) $880,000Payment of operating expenses (2) (660,000)Payment of income taxes (3) (85,000)


Cash flows from investing activities:

Sale of investments 50,000Net cash flows from investing activities 50,000

Cash flows from financing activities:

Proceeds from issue of common stock 100,000Payment of dividends (80,000)

Net cash flows from financing activities 20,000Increase in cash 205,000Cash and cash equivalents, January 1 70,000

Cash and cash equivalents, December 31 $275,000

(1)$900,000 in service revenue less $20,000 increase in accounts receivable.

(2)$700,000 in operating expenses less $30,000 in depreciation less $10,000 increasein accounts payable.

(3)$80,000 in income tax expense plus $5,000 decrease in income taxes payable.


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Requirement 2

Diversified Portfolio Corporation




Net income $120,000Adjustments for noncash effects:

Depreciation expense 30,000Increase in accounts receivable (20,000)Increase in accounts payable 10,000Decrease in income taxes payable (5,000)



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Problem 4-61. Restructuring is an example of an event that is either unusual or infrequent, but not

both. Restructuring costs should be included in income from continuing operations

but reported as a separate income statement component. The item is reportedgross, not net of tax as with extraordinary gains and losses.2. The extraordinary gain should be presented, net of tax, in the income statement

below income from continuing operations. Also, earnings per share for incomefrom continuing operations and for the extraordinary item should be disclosed.

3. The correction of the error should be treated as a prior period adjustment tobeginning retained earnings, not as an adjustment to current year's cost of goodssold. In addition, the 2005 financial statements should be restated to reflect thecorrection, and a disclosure note is required that communicates the impact of the

error on 2005 income.


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Problem 4-7

ALEXIAN SYSTEMS, INC.Income Statement


($ in millions except per share date)

Net sales revenue ............................................... $425Cost of goods sold ............................................. [1] 265Gross profit ....................................................... 160

Operating expenses:Selling and administrative ............................... [2] $128Restructuring costs .......................................... 26

Total operating expenses ............................. 154Operating income .............................................. 6

Other income:Interest revenue ............................................... 3Gain on sale of assets ...................................... 6

Total other income ....................................... 9

Income before income taxes and extraordinaryitem ............................................................... 15

Income tax expense ........................................... [3] 6Income before extraordinary item ......................Extraordinary gain (net of $48 in taxes)....................

Net income ........................................................

9[4] 72

$ 81

Earnings per share:Income before extraordinary item ......................Extraordinary gain .............................................

Net income ........................................................

$ 0.453.60

$ 4.05

[1]$270 - 5 (prior period adjustment)[2]$154 - 26 (restructuring costs)

[3]40% x $15[4]$120 less taxes of $48 (40% x $120)

Note: The difference in net income of $3 million ($81 million compared to $78 million on theoriginal income statement) is the effect of the inventory error of $5 million, less the 40% tax effect.


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Problem 4-8

REMBRANDT PAINT COMPANY


($ in thousands, except per share

amounts)

Sales revenue ................................................................. $18,000Cost of goods sold ......................................................... 10,500Gross profit ................................................................... 7,500Operating expenses:

Selling and administrative .......................................... $2,500Restructuring costs ..................................................... 800 3,300

Operating income .......................................................... 4,200

Interest income (expense), net ....................................... (150)Income from continuing operations before income taxes

and extraordinary item ............................................... 4,050Income tax expense ....................................................... 1,215Income from continuing operations before extraordinary

item ........................................................................... 2,835Discontinued operations:

Income from operations of discontinued component(including gain on disposal of $2,000) .................................... 400

Income tax expense .................................................... 120Income on discontinued operations ............................ 280

Income before extraordinary item .................................. 3,115Extraordinary gain (net of $900 tax expense) .................... 2,100Net income..................................................................... 5,215

Earnings per share:Income from continuing operations before extraordinary

item ............................................................................ $ 5.67Income on discontinued operations ................................ .56Extraordinary gain ......................................................... 4.20Net income .................................................................... $10.43


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Problem 4-9

Requirement 1

2005 Cash:2005 Cash + Net increase in cash = 2006 Cash2005 Cash + 61 = 1202005 Cash = 59

2006 A/R:

2005 A/R + Cr. Sales Cash collections = 2006 A/R84 + 80 71 = 93

2005 Inventory:

2005 A/P + Purchases Cash Paid = 2006 A/P30 + Purchases 30 = 40Therefore, Purchases = 402005 Inventory + Purchases 2006 Inventory = Cost of goods sold2005 Inventory + 40 60 = 322005 Inventory = 52

2005 Accumulated depreciation:

Gain on sale of equipment was 15; Cash received was 40; therefore, book value of

equipment was 25. Since the cost of equipment sold was 50 (200 - 150), accumuladepreciation on equipment sold must have been 25.

2005 Accumulated depreciation + Depreciation expense Accumulated depreciatioequipment sold = 2006 Accumulated depreciation2005 Accumulated depreciation + 10 25 = 402005 Accumulated depreciation = 30 + 25 = $55


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Problem 4-9 (continued)

2005 Total assets:

$59 + 84 + 52 + 200 55 = $340

2006 Total assets:$120 + 93 + 60 + 150 40 = $383

2005 Income taxes payable:

2005 Inc. taxes payable + Inc. tax expense Income taxes paid =2006 Inc. taxes payable2005 Inc. taxes payable =2006 Inc. taxes payable + Taxes paid Inc. tax expense2005 Inc. taxes payable = 22 + 9 7 = $24

2006 Retained earnings:2005 R/E + Net income Dividends = 2006 R/E

47 + 28 3 = 72

2005 Total liabilities and shareholders equity:

$30 + 9 + 24 + 230 + 47 = $340

2006 Total liabilities and shareholders equity:

$40 + 9 + 22 + 240 + 72 = $383


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Requirement 2

Grandview Corporation


($ in millions)


Net income $ 28Adjustments for noncash effects:

Depreciation expense 10Gain on sale of equipment (15)Increase in accounts receivable1 (9)

Increase in inventory2

(8)Increase in accounts payable3 10Decrease in income taxes payable4 (2)

Net cash flows from operating activities $14

1 $93 842 $60 523 $40 304 $22 24


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Judgment Case 4-1

Requirement 1The term earnings quality refers to the ability of reported earnings (income) topredict a companys future earnings. After all, an income statement simply reports onevents that already have occurred. The relevance of any historical-based financialstatement hinges on its predictive value.

Requirement 2

To enhance predictive value, analysts try to separate a companys transitoryearningseffects from its permanent earnings. Transitory earnings effects result fromtransactions or events that are not likely to occur again in the foreseeable future, or

that are likely to have a different impact on earnings in the future.Requirement 3

An often-debated contention is that, within GAAP, managers have the power, to

a limited degree, to manipulate reported company income. And the manipulation isnot always in the direction of higher income. Many believe that manipulating incomereduces earnings quality because it can mask permanent earnings.

Requirement 4

You would consider the size of the gain in relation to net income, the size of thecompanys investment portfolio, and the frequency of gains and losses from the sale

of investment securities in past years. The main objective is to determine thelikelihood of this type of gain occurring again in the future.

CASES


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Judgment Case 4-2

Requirement 1

Restructuring costs include costs associated with shutdown or relocation offacilities or downsizing of operations. Facility closings and related employee layoffs

translate into costs incurred for severance pay and relocation costs as well as assetwrite-downs or write-offs.

Requirement 2

Prior to 2003, restructuring costs were recognized (expensed) in the period thedecision to restructure was made, not in the period or periods in which the actualactivities took place. Now, restructuring costs are expensed in the period(s) incurred.

Requirement 3

Restructuring costs would be included as an operating expense in a multi-step

income statement.

Requirement 4

An analyst must interpret restructuring charges in light of a companys pasthistory in this area. Information in disclosure notes describing the restructuring andmanagement plans related to the business involved also can be helpful.

Judgment Case 4-3No. Companies generally prefer to report earnings that follow a smooth, regular

upward path. They try to avoid declines, but they also want to avoid increases thatvary wildly from year to year. It is better to have two years of 15% earningsincreases than a 30% gain one year and none the next. As a result, some companiesbank earnings by understating them in particularly good years and use the banked

profits to increase earnings in bad years.


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Real World Case 4-4

Requirement 1

Companies often voluntarily provide a pro forma earnings number when theyannounce annual or quarterly earnings calculated according to GAAP. These pro

forma earnings numbers are managements view of permanent earnings. These proforma earnings numbers are controversial as they represent managements biased viewof permanent earnings and should be interpreted in that light.

Requirement 2

The term earnings quality refers to the ability of reported earnings (income) topredict a companys future earnings. Management believes that pro forma earningsare of much higher quality than reported earnings because they are more indicative offuture profitability.

Requirement 3

There are some obvious reconciling items, to include restructuring costs andother special charges of $1,170 million, Inventory charges of $2,249 million and in-

process research and development of $109 million. Cisco offered the followingreconciliation ($ in millions):

GAAP loss $(2,693)Add:

Restructuring costs and other special charges $1,170In-process research and development 109

Amortization of goodwill and other acquisition costs* 346Payroll tax on stock options exercised 10Inventory charges 2,249

Total adjustments 3,884Tax effects (approximately 24.7% tax rate) 961

Net of tax adjustments 2,923

Pro forma net income $ 230

*New accounting standards discussed in Chapters 10 and 11 require thatgoodwill no longer be amortized. This standard became effective after August of2001.


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Communication Case 4-5The critical question that student groups should address is whether or not the gain

on the sale of the timber tracts should be reported as an extraordinary item on the 2006income statement. There is no right or wrong answer. The process of developing the

proposed solutions will likely be more beneficial than the solutions themselvesStudents should benefit from participating in the process, interacting first with othergroup members, then with the class as a whole.

Solutions should address the following issues:1. Is the gain material? A consensus should be reached that the gain is material.2. Is the event both unusual and infrequent? Debate should center on the critica

issue of whether the event is likely to occur again in the foreseeable future.3. If the event is deemed to require presentation as an extraordinary item, the

gain should be reported net of tax below income from continuing operations

A disclosure note also is required and earnings per share disclosure shouldreflect the income statement presentation.

As a real world example of a similar situation, in 1974 Johns ManvilleCorporation, manufacturer of asbestos products, reported a $21 million extraordinarygain from the sale of timber tracts. No disclosure note was provided to explain theevent, so we can only speculate as to the circumstances leading to the company's

presentation of the gain as extraordinary.It is important that each student actively participate in the process. Domination

by one or two individuals should be discouraged. Students should be encouraged to

contribute to the group discussion by (a) offering information on relevant issues, and(b) clarifying or modifying ideas already expressed, or (c) suggesting alternativedirection.


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Communication Case 4-6Suggested Grading Concepts and Grading Scheme:

Content (70%)

______ 10 Is the loss material?

______ 25 Lists the alternative treatments._____ Present before-tax amount as a separate line item._____ Present the after-tax amount as an extraordinary item._____ In either case, disclosure is required.

______ 25 Cites the appropriate authoritative pronouncement,APBO 30, and discusses the concepts of unusual

and infrequent in the context of the companys environment.

______ 10 A clear, well supported recommendation is made.____

______ 70 points

Writing (30%)______ 6 Terminology and tone appropriate to the audience of a chief

financial officer.

______ 12 Organization permits ease of understanding._____ Introduction that states purpose._____ Paragraphs that separate main points.

______ 12 English_____ Sentences grammatically clear and well organized,

concise._____ Word selection._____ Spelling._____ Grammar and punctuation.

__________ 30 points


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Case 4-6 (continued)

The following is provided as an example.August, 1990

TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS)

FROM: John Doe, Controller (CHHS)

RE: Income Statement treatment of October 17, 1989, earthquake damage costs.

A decision on the income statement treatment of the earthquake damage costsinvolves a number of considerations. First, the damage costs are clearly materialInclusion of the costs in earnings results in an increase in the net loss for the fiscalyear ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only

two options for the income statement presentation of the loss:1. Present the before-tax amount of the loss ($27.5 million) as a separate line

item in the income statement.2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary

item, below income from continuing operations.

In both cases, a disclosure note would be required to explain the loss.

The appropriate authoritative pronouncement pertaining to this case isAccounting Principles Board Opinion No. 30. The opinion states that judgment isrequired in determining whether or not an event warrants separate reporting in theincome statement as an extraordinary item. However, the following broad guideline is

provided:

Extraordinary items are events and transactionsthat are distinguished by their unusual nature andby the infrequency of their occurrence.(par. 20)

The opinion adds that the characteristics of unusual nature and infrequency ofoccurrence must be considered in light of the environment in which the company

operates.These characteristics are only aids in answering the important question: What isthe likelihood that this event will occur again in the foreseeable future? If it is notlikely to occur again, then this should be communicated to financial statement users

by segregating the income effect of the event as an extraordinary item. This will helpthem in using the income statement to predict future cash flows.


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Case 4-6 (concluded)

RECOMMENDATION

I recommend that the earthquake damage costs be treated as an extraordinaryloss, net of tax, in the income statement for the fiscal year ended August 4, 1990. Inaddition, earnings per share for income both before and after the loss must be

presented. While many earthquakes do occur in California, extremely largeearthquakes causing significant amounts of damage are both unusual and infrequent. Ido not believe that this type of loss will occur again in the foreseeable future.


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Ethics Case 4-7Discussion should include these elements.

Facts:

The company incurred $10 million in expenses related to a product recall. Thecompany had experienced product recalls in the past and they do occur in the industryTo show a profit from continuing operations, Jim Dietz, the controller, wants to reportthe $10 million as an extraordinary loss, rather than as an expense included inoperating income. He tells the CEO that the company has never had a product recall

of this magnitude and that the company fixed the design flaw and upgraded qualitycontrol.

Extraordinary items are gains and losses that are material, and result from eventsthat are both unusual andinfrequent. These criteria must be considered in light of theenvironment in which the entity operates. There obviously is a considerable degree of

subjectivity involved in the determination. The concepts of unusual and infrequentrequire judgment. In making these judgments, an accountant should keep in mind theoverall objective of the income statement. The key question is how the event relates toa firms future profitability. If it is judged that the event, because of its unusual natureand infrequency of occurrence, is not likely to occur again, separate reporting as anextraordinary item is warranted.

Ethical Dilemma:

It appears from the facts of the case that it would be difficult for the company tocome to the conclusion that a material product recall is not likely to occur again in theforeseeable future. This type of event has occurred before and is common in theindustry. While a subjective judgment, extraordinary treatment of the $10 milliondoes not appear warranted. Is the obligation of Jim and the CEO to maximize incomefrom continuing operations, the company's position on the stock market andmanagement bonuses stronger than their obligation to fairly present accountinginformation to the users of financial statements?

Who is affected?

Jim Dietz

CEO and other managersOther employeesShareholdersPotential shareholders from the stock market

CreditorsCompany auditors


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Research Case 4-8

Requirement 1

Most would agree that the events of September 11, 2001 were extraordinary.

The terrorist attacks were unprecedented in terms of the magnitude of the lossesincurred, the number of entities affected, the unprecedented federal ground stop orderthat closed the U.S. air travel system for over 24 hours, and the unprecedented effortsundertaken by the U.S. and other nations to prevent future terrorist attacks.

Requirement 3

The EITF was initially reluctant to address the issue because of its importance.However, timely accounting guidance was necessary to help companies in decidinghow to measure and report the losses sustained as a result of the attacks. The TaskForce noted that without such guidance, financial statement preparers and auditors

would be faced with individually resolving the difficult questions presented by thisissue. The FASBs elaborate process would have not provided the necessary guidancein a timely manner.

Requirement 4

The Task Force concluded that despite the incredible nature of the September 11events, extraordinary item financial reporting treatment would not be an effective wayto communicate the financial effects of those events and, therefore, should not be usedin this case. The Task Force noted that it would be impossible to isolate and thereforedistinguish, in a consistent way, the effects of the September 11 events in any single

line item on companies financial statements because of the inability to separate lossesthat are directly attributable to the events from those that were not.


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Judgment Case 4-9Financial Statement

Presentation

Situation Treatment (a-g) (CO, BC, or RE)1. b CO2. c RE3. f CO4. g CO5. a BC6. b CO7. e BC8. d. RE

Judgment Case 4-101. The loss is not unusual or infrequent. It is included in income from continuing

operations along with other gains and losses.2. The sale of the financing component is treated as a discontinued operation. The

gain or loss from the sale of the assets along with income or loss generated by thecomponent is presented below income from continuing operations.

3. A change in depreciation method is treated as a change in accounting estimateachieved by a change in accounting principle. Changes in estimates are accounted

for prospectively. The remaining book value is depreciated, using the new methodover the remaining useful life.

4. This event is not unusual but may be infrequent. It usually is presented as aseparate line item included in income from continuing operations.

5. The correction of an error is treated as a prior period adjustment. The effect of thecorrection is not included in income, but as an adjustment to retained earningsPrior years financial statements are restated to correct the error.

6. This event requires no unusual treatment. The lipstick line does not qualify as acomponent of an entity requiring treatment as a discontinued operation. The losson sale of the assets of the product line is included in continuing operations along

with other gains and losses.


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International Case 4-11Differences in income statement presentation:

1. The title of the statement is "Group Profit and Loss Account" as opposed to

Income Statement.2. The term "turnover" is used instead of sales or revenue.3. The current years turnover and operating profit are presented for both continuing

operations and for acquisitions. In the U.S., the income effect of acquisitions is notdisclosed separately in the income statement. That information is contained in adisclosure note.

4. The Cadbury statement contains a column for exceptional items. In the U.S., theseexceptional items are either separately reported below continuing operations, or arereported as a separate line item in continuing operations.

5. Dividends on ordinary shares are deducted on the Cadbury Schweppes statement to

arrive at "profit retained." In the U.S., dividends to shareholders do not appear inthe income statement. They are shown as distributions to owners in either thestatement of shareholders' equity or the statement of retained earnings.

6. There is no earnings per share presentation on the face of the statement as therecommonly is in the U.S.


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Judgment Case 4-12It would be nice to think that management makes all accounting choices in the

best interest of fair and consistent financial reporting. Unfortunately, other motives

influence the choices among accounting methods and whether to change methods. Ithas been suggested that the effect of choices on management compensation, onexisting debt agreements, and on union negotiations each can affect managementsselection of accounting methods.1 For instance, research has suggested that managersof companies with bonus plans are more likely to choose accounting methods thatmaximize their bonuses (often those that increase net income).2 Other research hasindicated that the existence and nature of debt agreements and other aspects of afirms capital structure can influence accounting choices.3 Whether a company isforbidden from paying dividends if retained earnings fall below a certain level, for

example, can affect the choice of accounting methods.

Choices made are not always those that tend to increase income. As you willearn in Chapter 8, many companies use the LIFO inventory method because itreduces income and therefore reduces the amount of income taxes that must be paidcurrently. Also, some very large and visible companies might be reluctant to reporthigh income that might render them vulnerable to union demands, governmentregulations, or higher taxes.4

1Watts, R.L. and J.L. Zimmerman, Towards a Positive Theory of the Determination of Accounting Standards, TheAccounting Review, January, 1978, and Positive Accounting Theory: A Ten Year Perspective, The Accounting

Review,January, 1990.2For example, see Healy, P.M., The Effect of Bonus Schemes On Accounting Decisions,Journal of Accounting andEconomics , April, 1985, and Dhaliwal, D.G. Salamon, and E. Smith, The Effect of Owner Versus Management

Control On The Choice Of Accounting Methods,Journal of Accounting and Economics, July, 1982.3Bowen, R.M., E.W. Noreen, and J.M. Lacy, Determinants of the Corporate Decision To Capitalize Interest,Journal

of Accounting and Econom

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