SOLUTIONS MANUAL For Financial Accounting Theory and Analysis Text and Cases 11th Edition. By Richar by StudyGuide

CHAPTER 1 Case l-1 a. The FASB had three primary goals in developing the Codification: 1. Simplify user access by codifying all authoritative US GAAP in one spot. 2. Ensure that the codified content accurately represented authoritative US GAAP as of July1, 2009. 3. Create a codification research system that is up to date for the released results of standard-setting activity. b. The Codification is expected to improve accounting practice by: 1. Reducing the amount of time and effort required to solve an accounting research issue 2. Mitigating the risk of noncompliance through improved usability of the literature 3. Provide accurate information with real-time updates as Accounting Standards Updates are released 4. Assisting the FASB with the research and convergence efforts. c. The FASB ASC is composed of the following literature issued by various standard setters: 1. Financial Accounting Standards Board (FASB) a. Statements (FAS) b. Interpretations (FIN) c. Technical Bulletins (FTB) d. Staff Positions (FSP) e. Staff Implementation Guides (Q&A) f. Statement No. 138 Examples. 2. Emerging Issues Task Force (EITF) a. Abstracts b. Topic D. 3. Derivative Implementation Group (DIG) Issues 4. Accounting Principles Board (APB) Opinions 5. Accounting Research Bulletins (ARB) 6. Accounting Interpretations (AIN) 7. American Institute of Certified Public Accountants (AICPA) a. Statements of Position (SOP) b. Audit and Accounting Guides (AAG)—only incremental accounting guidance c. Practice Bulletins (PB), including the Notices to Practitioners elevated to Practice Bulletin status by Practice Bulletin 1 d. Technical Inquiry Service (TIS)—only for Software Revenue Recognition Additionally, in an effort to increase the utility of the FASB ASC for public companies, relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance have been included for reference in the Codification, such as: 1. 2. 3.

Regulation S-X (SX) Financial Reporting Releases (FRR)/Accounting Series Releases (ASR) Interpretive Releases (IR) 6

SEC Staff guidance in: a. Staff Accounting Bulletins (SAB) b. EITF Topic D and SEC Staff Observer comments d. The FASB ASC contains all current authoritative accounting literature. However, if the guidance for a particular transaction or event is not specified within it, the first source to consider is accounting principles for similar transactions or events within a source of authoritative GAAP. If no similar transactions are discovered, nonauthoritative guidance from other sources may be considered. Accounting and financial reporting practices not included in the Codification are nonauthoritative. Sources of nonauthoritative accounting guidance and literature include, for example, the following: i. Practices that are widely recognized and prevalent either generally or in the industry ii. FASB Concepts Statements iii. American Institute of Certified Public Accountants (AICPA) Issues Papers iv. International Financial Reporting Standards of the International Accounting Standards Board Pronouncements of professional associations or regulatory agencies v. Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids vi. Accounting textbooks, handbooks, and articles

Case 1-2 a.

Inclusion or omission of information that materially affects net income harms particular stakeholders. Accountants must recognize that their decision to implement (or delay) reporting requirements will have immediate consequences for some stakeholders.

Yes. Because the FASB standard results in a fairer presentation, it should be implemented as soon as possible--regardless of its impact on net income.

The accountant's responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Hoger fulfills this task.

Potential lenders and investors, who read the financial statement and rely on its fair representation of the financial condition of the company, have the most to gain by early implementation. A stockholder who is considering the sale of stock may be harmed by early implementation that lowers net income (and may lower the value of the stock).

Case 1-3 a.

CAP. The Committee on Accounting Procedure, CAP, which was in existence from 1939 to 1959, was a natural outgrowth of AICPA (then AIA) committees, which were in existence during the period 1933 to 1938. The committee was formed in direct response to the criticism received by the accounting profession during the financial crisis of 1929 and the years thereafter. The authorization to issue pronouncements on matters of accounting principles and procedures was based on the belief that the AICPA had the responsibility to establish practices that would become generally accepted by the profession and by corporate management. 7

As a general rule, the CAP directed its attention, almost entirely, to resolving specific accounting problems and topics rather than to the development of generally accepted accounting principles. The committee voted on the acceptance of specific Accounting Research Bulletins published by the committee. A two-thirds majority was required to issue a particular research bulletin. The CAP did not have the authority to require acceptance of the issued bulletins by the general membership of the AICPA, but rather received its authority only upon general acceptance of the pronouncement by the members. That is, the bulletins set forth normative accounting procedures that "should be" followed by the accounting profession, but were not "required" to be followed. It was not until well after the demise of the CAP, in 1964, that the Council of the AICPA adopted recommendations that departures from effective CAP Bulletins should be disclosed in financial statements or in audit reports of members of the AICPA. The demise of the CAP could probably be traced by four distinct factors: (1) the narrow nature of the subjects covered by the bulletins issued by the CAP, (2) the lack of any theoretical groundwork in establishing the procedures presented in the bulletins, (3) the lack of any real authority by the CAP in prescribing adherence the procedures described by the bulletins, and (4) the lack of any formal representation on the CAP of interest groups such as corporate managers, governmental agencies, and security analysts. APB. The objectives of the APB were formulated mainly to correct the deficiencies of the CAP as described above. The APB was thus charged with the responsibility of developing written expression of generally accepted accounting principles through consideration of the research done by other members of the AICPA in preparing Accounting Research Studies. The committee was in turn given substantial authoritative standing in that all opinions of the APB were to constitute substantial authoritative support for generally accepted accounting principles. If an individual member of the AICPA decided that a principle of procedure outside of the official pronouncements of the APB had substantial authoritative support, the member had to disclose the departure from the official APB opinion in the financial statements of the firm in question. The membership of the committee comprising the APB was also extended to include representation from industry, government, and academe. The opinions were also designed to include minority dissents by members of the board. Exposure drafts of the proposed opinions were readily distributed. The demise of the APB occurred primarily because the purposes for which it was created were not being accomplished. Broad generally accepted accounting principles were not being developed. The research studies supposedly being undertaken in support of subsequent opinions to be expressed by the APB were often ignored. The committee in essence became a simple extension of the original CAP in that only very specific problem areas were being addressed. Interest groups outside of the accounting profession questioned the appropriateness and desirability of having the AICPA directly responsible for the establishment of GAAP. Politicization of the establishment of GAAP had become a reality because of the far-reaching effects involved in the questions being resolved. FASB. The formal organization of the FASB represents an attempt to vest the responsibility of establishing GAAP in an organization representing the diverse interest groups affected by the use of GAAP. The FASB is independent of the AICPA. It is independent, in fact, of any private or governmental organization. Individual CPAs, firms of CPAs, accounting educators, and 8

representatives of private industry will now have an opportunity to make known their views to the FASB through their membership on the Board. Independence is facilitated through the funding of the organization and payment of the members of the Board. Full-time members are paid by the organization and the organization itself is funded solely through contributions. Thus, no one interest group has a vested interest in the FASB. Conclusion. The evolution of the current FASB certainly does represent "increasing politicization of accounting standard setting." Many of the efforts extended by the AICPA can be directly attributed to the desire to satisfy the interests of many groups within our society. The FASB represents, perhaps, just another step in this evolutionary process. b.

Arguments for politicization of the accounting rule-making process: 1.

Accounting depends in large part on public confidence for its success. Consequently, the critical issues are not solely technical, so all those having a bona fide interest in the output of accounting should have some influence on that output.

There are numerous conflicts between the various interest groups. In the face of this, compromise is necessary, particularly since the critical issues in accounting are value judgments, not the type which are solvable, as we have traditionally assumed, using deterministic models. Only in this way (reasonable compromise) will the financial community have confidence in the fairness and objectivity of accounting rule making.

Over the years, accountants have been unable to establish, on the basis of technical accounting elements, rules, which would bring about the desired uniformity and acceptability. This inability itself indicates rule setting is primarily consensual in nature.

The public accounting profession, through bodies such as the Accounting Principles Board, made rules which business enterprises and individuals "had" to follow. For many years, these businesses and individuals had little say as to what the rules would be, in spite of the fact that their economic well being was influenced to a substantial degree by those rules. It is only natural that they would try to influence or control the factors that determine their economic well being.

Arguments against the politicization of the accounting rule-making process: 1.

Many accountants feel that accounting is primarily technical in nature. Consequently, they feel that substantive, basic research by objective, independent and fair-minded researchers ultimately will result in the best solutions to critical issues, such as the concepts of income and capital, even if it is accepted that there isn't necessarily a single "right" solution.

Even if it is accepted that there are no "absolute truths" as far as critical issues are concerned, many feel that professional accountants, taking into account the diverse interests of the various groups using accounting information, are in the best position, because of their independence, education, training, and objectivity, to decide what generally accepted accounting principles ought to be.

The complex situations that arise in the business world require that trained accountants develop the appropriate accounting principles. 9

The use of consensus to develop accounting principles would decrease the professional status of the accountant.

This approach would lead to "lobbying" by various parties to influence the establishment of accounting principles.

Case 1-4 a.

The term "accounting principles" in the auditor's report includes not only accounting principles but also\practices and the methods of applying them. Although the term quite naturally emphasizes the primary or fundamental character of some principles, it includes general rules adopted or professed as guides to action in practice. The term does not however, mean rules from which there can be no deviation. In some cases the question is which of several partially relevant principles has determining applicability. Neither is the term "accounting principles" necessarily synonymous with accounting theory. Accounting theory is the broad area of inquiry devoted to the definition of objectives to be served by accounting, the development and elaboration of relevant concepts, the promotion of consistency through logic, the elimination of faulty reasoning, and the evaluation of accounting practice.

Generally accepted accounting principles are those principles (whether or not they have only limited usage) that have substantial authoritative support. Whether a given principle has authoritative support is a question of fact and a matter of judgment. Since September 15, 2009 the primary source of GAAP has been the FASB’s accounting standards codification. However, if the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthoritative guidance from other sources (FASB ASC 105-10-5-2).. The CPA is responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within bounds of generally accepted accounting principle.

The auditor’s report states that a company’s financial statements present “fairly,” in all material respects, its financial position, based on his or her judgment as to whether the accounting principles selected and applied have general acceptance and that the accounting principles selected are appropriate given the circumstances. This statement is necessary because there are many areas where companies make choices among and between accounting principles (Depreciation method, inventory cost flow assumptions, etc). Therefore,, it is expected that financial reports are prepared in a manner that reflects the underlying economic events and activities of the reporting entity. This expectation was stressed in SAS No. 90 which stated, "In each SEC engagement, the auditor should discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the entity's accounting principles applied in its financial reporting. The discussion should also include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements. “ As a consequence, the choices of accounting principles made by one company are often different than those made by another company.

Case 1-5 A factor that influenced the development of accounting during the 19th century was the evolution of joint ventures into business corporations in England. The fact that many individuals, external to the business, needed information about the corporation's activities created the 10

necessity for periodic reports. Additionally, the emerging existence of corporations created the need to distinguish between capital and income. The statutory establishment of corporations in England in 1845 stimulated the development of accounting standards, and laws were subsequently passed that were designed to safeguard shareholders against improper actions by corporate officers. Dividends were required to be paid from profits, and accounts were required to be kept and audited by persons other than the directors. However, initially anyone could claim to be an accountant, as there were no organized professions or standards of qualifications. The industrial revolution and the succession of Companies Acts in England also served to increase the need for professional standards and accountants. In the later part of the 19th century, the industrial revolution arrived in the United States, and with it came the need for more formal accounting procedures and standards. This period was also characterized by widespread speculation in the securities markets, watered stocks, and large monopolies that controlled segments of the United States economy. In the 19th century the progressive movement was established in the United States, and in 1898 the Industrial Commission was formed to investigate and report on questions relating to immigration, labor, agriculture, manufacturing, and business. Although no accountants were either on the Commission or used by the Commission, a preliminary report issued in 1900 suggested that an independent public accounting profession should be established in order to curtail observed corporate abuses. Although most accountants did not necessarily subscribe to the desirability of the progressive reforms, the progressive movement conferred specific social obligations on accountants. As a consequence accountants generally came to accept three general levels of progressiveness: (1) a fundamental faith in democracy, a concern for morality and justice and a broad acceptance of the efficiency of education as a major tool in social amelioration; (2) an increased awareness of the social obligation of all segments of society and introduction of the idea of accountability to the public of business and political leaders; and (3) an acceptance of pragmatism as the most relevant operative philosophy of the day. The major concern of accounting during the early 1900s was the development of a theory that could cope with corporate abuses that were occurring at that time, and capital maintenance emerged as a concept. This concept evolved from maintaining invested capital intact, to the maintenance of the physical productive capacity of the firm, to the maintenance of real capital. In essence this last view of capital maintenance was an extension of the economic concept of income (see Chapter 3) that there could be no increase in wealth unless the stockholder or the firm were better off at the end of the period than at the beginning. During the period 1900-1915 the concept of income determination was not well developed. There was, however, a debate over which financial statement should be viewed as most important, the balance sheet or the income statement. Implicit in this debate was the view that either the balance sheet or the income statement must be viewed as fundamental and the other residual, and that relevant values could not be disclosed in both statements. The 1904 International Congress of Accountants marked the initial development of the organized accounting profession in the United States, although there had been earlier attempts to organize and several states had state societies. At this meeting, the American Association of 11

Public Accountants was formed as the professional organization of accountants in the United States. In 1916, after a decade of bitter interfactional disputes, this group was reorganized into the American Institute of Accountants (AIA). The American Association of the University Instructors in Accounting was also formed in 1916. Initially this group focused on matters of curriculum development, and it was not until much later that it attempted to become involved in the development of accounting theory. World War I changed the public's attitude toward the business sector. Many people believed that the successful completion of the war could be, at least partially, attributed to the ingenuity of American businesses. As a consequence, the public perceived that business had reformed, and external regulation was no longer necessary. The accountant's role changed from a protector of third parties to the protector of business interests. Critics of accounting theory during the 1920s suggested that accountants abdicated the stewardship role, placed too much emphasis on the needs of management, and permitted too much flexibility in financial reporting. During this time financial statements were viewed as the representations of management, and accountants did not have the ability to require businesses to use accounting principles they did not wish to employ.

Case 1-6 a.

Historically, accounting has been considered a highly trustworthy profession. Public accounting firms trained new accountants in the audit function with oversight from senior partners who believed that their firm’s integrity rode on every engagement. That is, new auditors were assigned client responsibility after minimal formal audit training. Most of the training of new accountants took place on-site, and the effectiveness of the new auditor depended on the effectiveness of the instructor. CPA firms have always called their customers “clients” and have worked hard to cultivate them. Partners routinely entertained clients at sporting events, country clubs, and restaurants, and many CPA firm employees later moved on to work in their clients’ firms. Any conflicts in these relationships were, at least partially, offset by the CPA firm’s commitment to professional ethics. These relationships changed as information technology advisory services grew in the late 1970s and early ’80s. Also in the mid-1980s, the AICPA lifted its ban on advertising. As a result, revenue generation became more critical to partners’ compensation. Thereafter, the profit structure of CPA firms changed dramatically and in 1999, revenues for management consulting accounted for more than 50 percent of the then Big Five’s revenue. As a result, the audit function evolved into a loss leader that public accounting firms offered in conjunction with vastly more lucrative consulting engagements. But as pubic accounting firms competed more aggressively on price for audit engagements, they were forced by cost considerations to reduce the number of procedures performed for each client engagement. This resulted in increased test of controls and statistical models, and fewer of the basic, timeconsuming tests of transactions that increase the likelihood of detecting fraud. In addition, junior auditors were frequently assigned the crucial oversight roles usually filled by senior partners, who were otherwise engaged in marketing activities to prospective clients. This reduced the effectiveness of the instructor–new accountant training process. 12

1. Arthur Andersen, formerly one the Big Five audit firms, has gone out of business. 2. In July 2002, President George W. Bush signed into law the Sarbanes-Oxley Bill, which imposes a number of corporate governance rules on publicly traded companies 3. Establishment of PCAOB.

Case 1-7 a.

The structure of the FASB is as follows. A board of trustees nominated by organizations whose members have special knowledge and interest in financial reporting is selected. The organizations originally chosen to select the trustees were the American Accounting Association; the AICPA; the Financial Executives Institute; the National Association of Accountants (The NAA’s name was later changed to Institute of Management Accountants in 1991) and the Financial Analysts Federation. In 1997 the Board of Trustees added four members from public interest organizations. The board that governs the FASB is the Financial Accounting Foundation (FAF). The FAF appoints the Financial Accounting Standards Advisory Council (FASAC), which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The number of members on the FASAC varies from year to year. The bylaws call for at least twenty members to be appointed. However, the actual number of members has grown to about thirty in recent years to obtain representation from a wider group of interested parties. The FAF appoints the Financial Accounting Standards Advisory Council, which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The FAF is also responsible for appointing the seven members of the FASB and raising the funds to operate the FASB. The FAF currently collects in excess of $23 million a year to support the activities of the FASB.

The members of the Financial Accounting Foundation are nominated by electors from nine organizations that support the activities of the FASB. These nine organizations are the AICPA, the Financial Executives Institute, the National Association of Accountants, the Financial Analysts Federation, the American Accounting Association, the Security Industry Association, and three not-for-profit organizations.

FASB ASC 1-1 Variable Interest Entities (VIEs) Special purpose entities are accounted for by using the requirements for variable interest entities (VIEs). The information for this question is found by searching the topic “variable interest entities.” 1. The definition of variable interest entities is contained in FASB ASC 810-10-25-20 2. The guidance of the consolidation of VIEs is contained in 810-10-05-8 to 13.

FASB ASC 1-2 Status of ARBs First search the glossary for the three terms Revenue recognition topic 605 13

Treasury stock topic 505-30 Comparative financial statements topic 205 Then Search ARB 43 in cross reference Look for topic 605 (revenue) in the results Treasury Stock Search ARB 43 in cross reference Look for topic 505- 30 (treasury stock) in the results Comparative Financial Statements Search ARB 43 in cross reference Look for topic 205 (comparative financial statements ) in the results

205-10-45 Use print function printer friendly with sources

FASB ASC 1-3 Accounting for the Investment Tax Credit Search investment tax credit Found at 740-10-25- 45 7 46 740-10-47-27 & 28 FASB ASC 1-4 SEC Comments 1. Search revenue recognition Found under customer payment and incentives 605-50-S99-1

Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 2. Search debt with conversions and other options Found under 470-20 -S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings 3. Search software cost of sales and services 14

Found under 985-705-S99 Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings FASB ASC 1-5 GAAP Guidelines Search “generally accepted accounting principles.” Found under 105-10 Room for Debate Debate 1-1 This question has no one correct answer. It is meant to get students talking about something that they probably haven’t thought about before. Students in favor of the SEC being the rule making body could argue that the FASB has failed to ensure that financial statements fairly present the results of operations. They could then cite the recent scandals. They could argue that the SEC has the power to regulate and they don’t see why the profession should then need to be self regulated. They could also argue that under the FASB there is too much flexibility and too much reliance on managerial intent, thereby allowing management to manage earnings and otherwise manipulate its financial statements. Moreover, lack of exercise of government direct oversight could result in diminishing the effectiveness of accountants to audit due to a potential erosion of independence. They could point to SarbanesOxley. Students in favor of the FASB making the rules could argue against big government. They could point out that government sets accounting standards in countries that are not capitalistic. The result in those countries is a cookie cutter approach to financial statements and lack of flexibility that leaves no room for professional judgment. Whereas, the standards provided by the FASB are aimed to provide financial statements that fairly present financial statements, taking into consideration the circumstances in which a company operates. They could also argue that accountants, not government officials, best understand their role and how best to measure and report financial information. Debate 1-2 Should the scope of accounting standards be narrowed further? Team 1. This question should prompt the student to investigate how management might benefit from alternative accounting choices. They can go to the web and find out that accounting choices provide managerial incentives that are either income increasing or income decreasing. They may also find instances that management can choose methods of presenting financial information that make the company appear less risky. Income-increasing choices afford management the ability to paint a better picture of company performance. Management may be inclined to select income increasing policies because

• • • • •

they believe the stock market will react favorably and their own personal wealth and position in the firm may be more secure. their bonus may be tied to the bottom line. The company may appear better able to pay suppliers and thus may be in a better position to negotiate favorable terms with suppliers The company may appear better able to repay debt and thus look good to a lender. Students can cite real-world examples, eg., World Com capitalized expenses

Income-decreasing choices may be selected by companies that • Are highly regulated, such as utility companies. Poor performance can support the notion that the company deserves a rate increase • If a company is having a bad year, it may choose to load up the income statement with expenses and losses so that it will appear better off in future years. • Have labor unions hope to fare better in negotiations for labor contracts Companies have used off-balance sheet financing to improve the perception of a company’s riskiness. Enron is a prime example. Enron used special purpose entities to hide debt from investors. The student can also argue that accounting choice can be used to provide more relevant financial statements. For example, SFAS 115 provides choices that are intended to result in financials that better disclose the results of management investment choices. Team 2. All of the above can be used as arguments against the proliferation of accounting choices. Narrowing accounting choices has been a goal of accounting professionals for many years. For example, one of the objectives of the APB was to narrow areas of difference in GAAP. Critics maintain that management is allowed too much leeway in the selection of the accounting procedures used in corporate financial reports. These criticisms revolve around two issues (1) Executive compensation is frequently tied to reported earnings, so management is inclined to adopt accounting principles that increase current revenues and decrease current expenses and (2) the value of a firm in the marketplace is determined by its stock price. This value is highly influenced by financial analysts’ quarterly earnings estimates. Managers are fearful that failing to meet these earnings estimates will trigger a sell-off of the company’s stock and a resultant decline in the market value of the firm. The large number of accounting frauds that were evident during recent years provide examples of the ways that management has manipulated financial statement in order to fool the public. Many of these cases might not have occurred if management were not afforded the discretion to choose accounting procedures and practices. In short, accounting choice can result in earnings management, fraudulent financial reporting, a lack of financial statement transparency, financial statements that are not reliable, and financial statements that are biased. WWW Case 1-8

The Securities and Exchange Commission (SEC) was created by the Securities Act of 1933 and the Securities Exchange Act of 1934, The SEC was created to administer various securities acts. Under powers provided by Congress, the SEC was given the authority to prescribe accounting principles and reporting practices. Nevertheless, because the SEC has generally acted as an overseer and allowed the private sector to develop accounting principles, and this authority has seldom been used. However, the SEC has exerted pressure on the accounting profession and has been especially interested in narrowing areas of difference in accounting practice. In 1936 the AICPA’s Committee on Accounting Procedure (CAP) was formed. This committee had the authority to issue pronouncements on matters of accounting practice and procedure in order to establish generally accepted practices. The works of the CAP were originally published in the form of Accounting Research Bulletins (ARBs); however, these pronouncements did not dictate mandatory practice and received authority only from their general acceptance. The ARBs were consolidated in 1953 into Accounting Terminology Bulletin No. 1, “Review and Resume,” and ARB No. 43. ARBs No. 44 through No. 51 were published from 1953 until 1959. The recommendations of these bulletins that have not been superseded are contained in the FASB Accounting Standards Codification (FASB ASC; discussed below) and referenced throughout this text where the specific topics covered by the ARBs are discussed. By 1959 the methods of formulating accounting principles were being questioned as not arising from research or based on theory. . The AICPA responded to the alleged shortcomings of the CAP by forming the Accounting Principles Board (APB). The objectives of this body were to advance the written expression of generally accepted accounting principles (GAAP), to narrow areas of difference in appropriate practice, to narrow areas of difference in appropriate practice and to discuss unsettled controversial issues. The pronouncements of this body were termed “APB Opinions.” In 1974 the APB was replaced with the Financial Accounting Standards Board. The pronouncements of this organization were originally terms Statements of Financial Accounting Standards. Subsequently, after the publication of the Accounting Standards Codification, they have been termed Accounting Standards Updates.

This term, initially proposed by Carman Blough, the first chief accountant of the SEC, is meant to mean authority of 'substantial weight' or importance, and not necessarily a majority view. Thus there might be three authoritative positions all of which are appropriate at a point in time before some standard is established. The majority may have gone in one direction, but the minority who were also considered 'authoritative' and could be used.

The SEC and the AICPA have been the sources of authority for compliance with accounting standards. The SEC has indicated that financial statements conforming to standards set by the FASB will be presumed to have authoritative support. The AICPA, in Rule 203 of the Code of Professional Ethics, requires that members prepare financial statements in accordance with GAAP. Failure to follow Rule 203 can lead to the loss of a CPA’s license to practice.

Case 1-9

CAP. The Committee on Accounting Procedure, CAP, which was in existence from 1939 to 1959, was a natural outgrowth of AICPA committees which were in existence during the period 1933 to 1938. The committee was formed in direct response to the criticism received by the accounting profession during the financial crisis of 1929 and the years thereafter. The 17

authorization to issue pronouncements on matters of accounting principles and procedures was based on the belief that the AICPA had the responsibility to establish practices that would become generally accepted by the profession and by corporate management. As a general rule, the CAP directed its attention, almost entirely, to resolving specific accounting problems and topics rather than to the development of generally accepted accounting principles. The committee voted on the acceptance of specific Accounting Research Bulletins published by the committee. A two-thirds majority was required to issue a particular research bulletin. The CAP did not have the authority to require acceptance of the issued bulletins by the general membership of the AICPA, but rather received its authority only upon general acceptance of the pronouncement by the members. That is, the bulletins set forth normative accounting procedures that “should be” followed by the accounting profession, but were not “required” to be followed. It was not until well after the demise of the CAP, in 1964, that the Council of the AICPA adopted recommendations that departures from effective CAP Bulletins should be disclosed in financial statements or in audit reports of members of the AICPA. The demise of the CAP could probably be traced to four distinct factors: (1) the narrow nature of the subjects covered by the bulletins issued by the CAP, (2) the lack of any theoretical groundwork in establishing the procedures presented in the bulletins, (3) the lack of any real authority by the CAP in prescribing adherence to the procedures described by the bulletins, and (4) the lack of any formal representation on the CAP of interest groups such as corporate managers, governmental agencies, and security analysts. APB. The objectives of the APB were formulated mainly to correct the deficiencies of the CAP as described above. The APB was thus charged with the responsibility of developing written expression of generally accepted accounting principles through consideration of the research done by other members of the AICPA in preparing Accounting Research Studies. The committee was in turn given substantial authoritative standing in that all opinions of the APB were to constitute substantial authoritative support for generally accepted accounting principles. If an individual member of the AICPA decided that a principle or procedure outside of the official pronouncements of the APB had substantial authoritative support, the member had to disclose the departure from the official APB opinion in the financial statements of the firm in question. The membership of the committee comprising the APB was also extended to include representation from industry, government, and academe. The opinions were also designed to include minority dissents by members of the board. Exposure drafts of the proposed opinions were readily distributed. The demise of the APB occurred primarily because the purposes for which it was created were not being accomplished. Broad generally accepted accounting principles were not being developed. The research studies supposedly being undertaken in support of subsequent opinions to be expressed by the APB were often ignored. The committee in essence became a simple extension of the original CAP in that only very specific problem areas were being addressed. Interest groups outside of the accounting profession questioned the appropriateness and desirability of having the AICPA directly responsible for the establishment of GAAP. Politicization of the establishment of GAAP had become a reality because of the far-reaching effects involved in the questions being resolved.

FASB. The formal organization of the FASB represents an attempt to vest the responsibility of establishing GAAP in an organization representing the diverse interest groups affected by the use of GAAP. The FASB is independent of the AICPA. It is independent, in fact, of any private or govern-mental organization. Individual CPAs, firms of CPAs, accounting educators, and representatives of private industry will now have an opportunity to make known their views to the FASB through their membership on the Board. Independence is facilitated through the funding of the organization and payment of the members of the Board. Full-time members are paid by the organization and the organization itself is funded solely through contributions. Thus, no one interest group has a vested interest in the FASB. Conclusion. The evolution of the current FASB certainly does represent “increasing politicization of accounting standards setting.” Many of the efforts extended by the AICPA can be directly attributed to the desire to satisfy the interests of many groups within our society. The FASB represents, perhaps, just another step in this evolutionary process. b.

Arguments for politicalization of the accounting rule-making process: 1. Accounting depends in large part on public confidence for its success. Consequently, the critical issues are not solely technical, so all those having a bona fide interest in the output of accounting should have some influence on that output. 2. There are numerous conflicts between the various interest groups. In the face of this, compromise is necessary, particularly since the critical issues in accounting are value judgments, not the type which are solvable, as we have traditionally assumed, using deterministic models. Only in this way (reasonable compromise) will the financial community have confidence in the fairness and objectivity of accounting rule-making. 3. Over the years, accountants have been unable to establish, on the basis of technical accounting elements, rules which would bring about the desired uniformity and acceptability. This inability itself indicates rule-setting is primarily consensual in nature. 4. The public accounting profession, through bodies such as the Accounting Principles Board, made rules which business enterprises and individuals “had” to follow. For many years, these businesses and individuals had little say as to what the rules would be, in spite of the fact that their economic well-being was influenced to a substantial degree by those rules. It is only natural that they would try to influence or control the factors that determine their economic well-being.

Arguments against the politicalization of the accounting rule-making process: 1. Many accountants feel that accounting is primarily technical in nature. Consequently, they feel that substantive, basic research by objective, independent and fair-minded researchers ultimately will result in the best solutions to critical issues, such as the concepts of income and capital, even if it is accepted that there isn’t necessarily a single “right” solution. 2. Even if it is accepted that there are no “absolute truths” as far as critical issues are concerned, many feel that professional accountants, taking into account the diverse interests of the various groups using accounting information, are in the best position, because of their independence, education, training, and objectivity, to decide what generally accepted accounting principles ought to be. 3. The complex situations that arise in the business world require that trained accountants develop the appropriate accounting principles. 4. The use of consensus to develop accounting principles would decrease the professional status of the accountant. 5. This approach would lead to “lobbying” by various parties to influence the establishment of ac-counting principles. 19

Case 1-10 The answer to this case requires an analysis of the financial statements of the two companies at the time it is assigned. Case 1-11 The answer to this case requires a visit to the Microsoft Corporation’s homepage at the time it is assigned. Financial Analysis Case The solutions to the financial analysis case depend upon the company and year selected.

CHAPTER 2

Case 2-1 a.

The FASB's conceptual framework study should provide benefits to the accounting community such as: 1. Guiding the FASB in establishing accounting standards on a consistent basis. 2. Determining bounds for judgment in preparing financial statements by prescribing the nature, functions, and limits of financial accounting and reporting. 3. Increasing users understanding of and confidence in financial reporting.

The two fundamental qualities that make accounting information useful for decision making are relevance and faithful representation. Relevant financial information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value and confirmatory value and is material. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information has confirmatory value if it provides feedback (confirms or changes) about previous evaluations. Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the FASB was not able to specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena but also must faithfully represent the phenomena that it purports to represent. A perfectly faithful representation has three characteristics: completeness, neutrality, and free from error. Although perfection is difficult or even impossible to achieve, the objective is to maximize those qualities to the extent possible. A complete depiction should include all information necessary for a user to understand the phenomenon being depicted. For some items, a complete depiction also might entail explanations of significant facts about the quality and nature of the items, factors, and circumstances that might affect their quality and nature and the process used to determine the numerical depiction. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutral information does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Information that is free from error will result in a more faithful representation of financial results. 21

Comparability, verifiability, timeliness, and understandability are the qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities also can be verified. Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is. However, some information can continue to be timely long after the end of a reporting period because, for example, some users might need to identify and assess trends. Understandability involves classifying, characterizing, and presenting information clearly and concisely. Case 2-2. a.

The Conceptual Framework Project is an attempt by the FASB to develop concepts useful in guiding the board in establishing standards and in providing a frame of reference for resolving accounting issues. Over the years this project first attempted to develop principles or broad qualitative standards to permit the making of systematic rational choices among alternative methods of financial reporting. Subsequently the project focused on how well these overall objectives could be achieved. The FASB has stated that it intends the Conceptual Framework Project to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues, for asking relevant questions, and for suggesting avenues for research. The Conceptual Framework Project has resulted in the issuance of eight statements of Financial Accounting Concepts that impact upon financial accounting: No.1-Objectives of Financial Reporting by Business Enterprises (superseded); No.2-Qualitative Characteristics of Accounting Information (Superseded); No.3-Elements of Financial Statements of Business Enterprises (Superseded); No.5Recognition and Measurement in Financial Statements of Business Enterprises; No.6Elements of Financial Statements;” No. 7-“Using Cash Flow Information and Present Value in Accounting Measurements” and No. 8 “Conceptual Framework for Financial Reporting (Chapters 1 & 3).

ii. The FASB has been criticized for failing to provide timely guidance on emerging implementation and practice problems. During 1984 the FASB attempted to respond to this criticism by (1) establishing a task force to assist in identifying issues and problems that might require action, the Emerging Issues Task Force, and (2) expanding the scope of the FASB Technical Bulletins in an effort to offer quicker guidance on a wider variety of issues. Emerging issues arise because of new types of transactions, variations in accounting for existing types of transactions, new types of securities, and new products and services. They frequently involve the company's desire to achieve "off balance sheet" financing or "off income statement" accounting. 22

The Emerging Issues Task Force was formed to assist the FASB in issuing timely guidance on these emerging issues. That is, the task force's responsibility is to identify emerging issues as they develop, investigate and review them, and finally to advise the board whether the issue merits its attention. The members of the task force all occupy positions that make them aware of emerging issues. The current members include the directors of accounting and auditing from 11 public accounting firms (including all of the "Big Four"), two representatives from the Financial Executives Institute, one from the National Association of Accountants and the Business Roundtable, and the FASB's Director of Research who serves as Chairman. b.

The Financial Accounting Standards Board, the Securities and Exchange Commission, and the American Institute of Certified Public Accountants have been criticized for imposing too many accounting standards on the business community. The Standards overload problem has been particularly burdensome on small businesses that do not have the necessary economic resources to research and apply all of the pronouncements issued by these sources Those who contend that there is a standards overload problem base their arguments on two allegations. 1. Not all GAAP requirements arc relevant to small business financial reporting needs. 2. Even when they are relevant, they frequently violate the pervasive cost benefit constraint. Critics of the standard-setting process for small business also assert that GAAP were developed primary to serve the needs of the securities market. Many small businesses do not raise capital in these markets therefore, it is contended that GAAP were not developed with small business needs in mind. Some of the consequences of the standards overload problem to small business are as follows. 1. If a small business omits a GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. 2. The cost of complying with GAAP requirements may cause a small business to forgo the development of other, more relevant information. 3. Small CPA firms that audit smaller companies must keep up to date on all of the same requirements as large international firms, but cannot afford the specialists that are available on a centralized basis in the large firms. Many accountants have argued for differential disclosure standards as a solution to the standards overload problem. That is, standards might be divided into two groups. One group would apply to business regardless of size. The second group would be applied selectively only to large businesses, small businesses, or particular industries. For example, the disclosure of significant accounting policies would pertain to all businesses, whereas a differential disclosure such as earnings per share would be applicable only to large businesses.

Case 2-3

b. Quantitative data are helpful in making rational economic decisions. Stated differently, quantitative data aid the decision maker in making choices among alternatives, so that the actions are correctly related to consequences. c.

i. ASOBAT defined accounting as “the process of identifying, measuring, and communicating economic information to permit informed judgments and decision by users of the information.” Both this definition and Sprouse and Moonitz believe that communicating information is helpful for users to make rational decisions and informed judgments’. ii. Similarly, SFAC No. 8 states that accounting information should be useful for investment decision-making. The user should be able to use accounting information to make decisions about investing in a company.

Case 2-4 a.

In describing continuity, Sprouse and Moonitz stated that in the absence of evidence to the contrary, the entity should be viewed as remaining in operation indefinitely. In the presence of evidence that the entity has a limited life, it should not be viewed as remaining in operation indefinitely.

No. Since a business is presumed to continue indefinitely, the value relevant to a purchaser is fair market value. This value measures the present value of future cash flows to the buyer. It is relevant for the buyer because the buyer presumes that the business will continue and thus will generate those future cash flows.

No. A bankruptcy provides evidence that the business is not expected to remain in operation indefinitely. In this case, the assets that are reported in the company’s balance sheet should be measured at net realizable value.

Case 2-5 a.

SFAC No. 6 defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” If your company is using a building to produce automobiles, the probable future economic benefit is the expected inflow of resources from the sales of automobiles. This benefit accrues to the company who may then use them, if it wishes, to make more automobiles. The prior transaction that caused the asset to exist is the acquisition of the building.

In this case, the probable future economic benefit is the net realizable value that the company will receive when it sells the building. Again, the acquisition of the building is the result of a prior transaction or event.

In this case, the probable future economic benefit is the inflow of resources that will eventually flow into the company when it produces the automobiles. The transaction that caused the asset to exist was the acquisition of the building.

Case 2-6 a.

Employees meet the definition of an asset. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can 24

obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred. Employees embody a probable future benefit that will contribute to future net cash flows. They will work so that the company can have revenues. The company will benefit because they control what the employees do on the job. Employment of the employees gave rise to the entity’s right to control the benefit. b.

No. According to SFAC No. 5, to report an asset in the balance sheet, it not only must meet the definition of an asset, but it must be capable of being measured.

i. The value would be more relevant because it would measure the expected future cash flows that the employees would be expected to generate. It would be less reliable because there is no precise method to measure the value of human capital. It can only be estimated. Therefore two measurements made by two different measurers are unlikely to be the same. ii. Yes. Representational faithfulness means that the items in the balance reflect what they purport to be. If human capital is an asset then reporting its estimated value would reflect the value of that asset and would as a result provide representational faithfulness.

Case 2-7 a.

According to SFAC No. 7 the bonds are distinguished by the uncertainty of their future cash flows. The bonds would sell at the present value of their future cash flows, discounted at the market rate of interest. The company with the better credit rating would yield a lower market rate, assuming that the stated rates for both companies are the same. So, if the stated rates are the same, Company A’s bond might be more valuable it its credit rating were better than Company B’s.

If both companies have the same credit rating, then the one reason that Company A’s bond would have a higher market value than would Company B’s bond would be that Company A’s bond has a shorter term than Company B’s bond. If they both have the same term, then Company A’s bond would sell for more than Company B’s bond if Company A were offering a higher stated interest rate.

FASB ASC FASB ASC 2-1 Use of Present Value The information on present value is contained in the FASB ASC at FASB ASC 820-10-55. It can be accessed through the glossary. FASB ASC 2-2 Search conceptual framework Found under 605 Revenue Recognition 10 Overall S99 SEC Materials FASB ASC 2-3 25

Search decision maker 10 hits FASB ASC 2-4 Search understandability Found under 715 compensation—Retirement Benefits > 10 Overall > 10 Objectives

FASB ASC 2-5 Search relevance – 15 hits FASB ASC 2-6 Search recognition and measurement-over 70 hits FASB ASC 2-7 Reporting Comprehensive Income is contained in sections FASB ASC 220-10. It is found by searching comprehensive income. FASB ASC 2-8 Search present value-over 100 hits Room for Debate Debate 2-1 Team 1: Arguments for capitalization of boxes. 1.

Objectives of financial reporting Decision usefulness requires that companies report the status of enterprise resources. The boxes provide future service potential. As such, they meet the definition of an asset found in SFAC No. 6. Hence, they are a resource that should be reported.

Definition of assets SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The boxes are assets. They will provide future economic benefits for a particular entity (Roper Co). The company will use them for at least 10 years. They result from past transaction - a purchase. 26

Qualitative Characteristics Relevance Capitalization is relevant because it provides information about outcomes of past transactions or events. The user is informed that the boxes are assets. They were purchased by the company, and the company intends to use them over an extended period of time. Hence their cost is not a current period expense. Faithfull Representation Capitalization provides reliability. Because the boxes will be used over an extended period of time, they meet the definition of an asset found in SFAC No. 6. Hence, capitalization presents the economic facts and provides information that is representationally faithful. If they are assets, they should be reported as such, rather than expensed, a representation that would not report them as they purport to be. Also, capitalization of the cost would be neutral because it would provide an unbiased representation of the economic substance of the purchase transaction.

Team 2 Arguments against the capitalization of the boxes. 1.

Materiality Materiality is the threshold for recognition. When the dollar amount is small, the particular accounting treatment will not affect the decisions of an informed user. In this case, the cost of boxes is clearly immaterial, implying that they need not be capitalized as assets.

Cost Constraint The benefits derived from capitalization should exceed the cost of capitalization. Since the cost of the boxes is not material, capitalization would not provide sufficient benefit, in terms of decision usefulness, to warrant this accounting treatment. Capitalization would require depreciation over the useful life of the boxes. This would require adjusting entries for a ten-year period. The amount of depreciation reported each period would be trivial and would have essentially no effect on earnings. Hence, the cost of the bookkeeping effort would be greater than the benefits, if any, derived.

Objectives of financial reporting The primary objective of financial reporting is decision usefulness. Accounting information should provide information that is useful to investors, creditors and other users in making decisions regarding investing, lending, etc. This implies that accounting information is relevant to the decision-maker. Even though the boxes will last 10 years, the cost is immaterial and hence irrelevant.

Qualitative Characteristics of accounting information Relevance

As stated above, relevance means that the information provided will make a difference in the decisions of investors, creditors and other users. The expenditure is immaterial and as such, the accounting treatment is irrelevant, and capitalization is irrelevant. Debate 2-2 The need for a universally accepted theory of accounting Team 1: A universally accepted theory of accounting is needed for the development of internally consistent accounting principles. Accounting practices have developed in response to changing economic conditions and, in some cases, in response to what are perceived as crises. For example, SFAS No. 114, was prompted to inconsistent practices of reporting impaired loans, and SFAS No. 94 was prompted by off-balance sheet recognition of lease liabilities. This piecemeal, reactionary approach to accounting has resulted in standards that are not only internally inconsistent, but are also inconsistent with international standards. A theory of accounting would provide a common basis for identifying and discussing issues. This is the goal of the FASB’s conceptual framework project. Such a theory could be used to help narrow the number of accounting choices currently available to management, thereby reducing management’s ability to manipulate financial statements to suit their personal, or company goals. As such, it could help guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient functioning of capital markets In addition to helping reduce managerial bias in reporting results of operations and financial position, a universally accepted theory of accounting could serve to reduce personal biases in the standard setting process itself. Reliance on such a theory could result in the development of those standards that are consistent with the theory itself. A universal theory of accounting would be consistent with the concepts-based approach to accounting standards described by the American Accounting Association. A universally accepted accounting theory could provide a basis for standard setting that would satisfy the following. 1. Economic substance, not the form, of a given transaction should guide its financial reporting. 2. The mapping between economic substance of a transaction and its financial statement representation could be supported by a common theoretical basis, thereby providing understandability and a common basis of comparison across companies and over time. Team 2: To date, no standard setting body has developed a universally accepted theory of accounting. An argument against a universal theory of accounting can be based on the complexity of the phenomena that financial statements purport to represent. According to SATTA, while there has been general agreement that the purpose of financial accounting is to provide economic data about accounting entities, divergent theories have emerged because of the way different theorists specified users of accounting data and the environment. For example, users might be defined either as the owners of the accounting entity or more broadly to include creditors, employees, regulatory agencies, and the general public. Similarly, the environment might be specified as a single source of information or as one of several sources of financial information. 28

SATTA discussed why none of the approaches to theory had gained general acceptance, SATTA raised six issues. 1. The problem with relating theory to practice. The real world is much more complex than the world specified in most accounting theories. For example, most theory descriptions begin with unrealistic assumptions such as holding several variables constant. 2. Allocation problem. Allocation is an arbitrary process. For example, the definition of depreciation as a rational and systematic method of allocation has led to a variety of interpretations of these terms. 3. The difficulty with normative standards. Normative standards are desired states; however, different users of accounting information have different desired states. As a result, no set of standards can satisfy all users. 4. The difficulties in interpreting security price behavior research. Market studies (such as the efficient market studies discussed in Chapter 4) attempt to determine how users employ accounting numbers. These studies have attempted to control for all variables except the one of interest, but there have been disagreements over whether their research designs have actually accomplished this goal. 5. The problem cost-benefit considerations accounting theories. A basic assumption of accounting is that the benefits derived from adopting a particular accounting alternative exceed its costs. However, most existing theories do no indicate how to measure benefits and costs. 6. Limitations of data expansion. At the time SATTA was published, a view was emerging that more information is preferable than less. Subsequent research has indicated that users have a limited ability to process accounting information. (The issue of information processing is discussed in Chapter 4.) The FASB’s conceptual framework project (CPF) cannot be viewed as a universally accepted theory of accounting, nor does the FASB purport that it is. The FASB intends the CFP to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues. For example, SFAC Nos. 1 and 2 can be described as the goals to guide practice. It does not even directly affect practice. Rather, the SFACs affect practice only by means of their influence on the development of new accounting standards. So, rather than a universally accepted theory of accounting, we have settled for the CFP, which does not provide all the answers, but has been relied upon to aid the standard-setting process. And, it has provided a basis to narrow alternatives and to eliminate those that are inconsistent with it. It also is used to guide the development of neutral standards, which aids in the allocation of scarce resources and the efficient function of capital markets In other words we can operate with concept-based accounting standards by relying upon the CFP rather than a universally accepted theory of accounting. The CFP has been criticized and will evolve to address criticism from the SEC that the objectives of the standards that are derived from it need to be more clearly defined, implementation guidance needs to be improved, scope exceptions need to be reduced and the asset-liability approach to standard setting should be retained WWW Case 2-8 29

The conceptual framework contains three levels. The apex, the first level, identifies the objective of financial reporting —that is, the purpose of financial reporting. The second level outlines the fundamentals, which are the qualitative characteristics that make accounting information useful, and the elements of financial statements (assets, liabilities, and so on). The third level identifies the implementation guidelines of recognition, measurement, and disclosure used in establishing and applying accounting standards and the specific concepts to put into practice the objective. These guidelines include the assumptions, principles, and constraints that describe the present reporting environment. Case 2-9 The qualitative characteristics of accounting information are: Primary Users The primary users of financial information are existing or potential investors, lenders, and other creditors, that is, its capital providers. Cost Constraint Cost is described in SFAC No. 8 as a pervasive constraint on the information that can be provided by financial reporting. The measurement, summarization, and reporting of financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. Qualitative Characteristics The qualitative characteristics are described in Chapter 3 of SFAC No. 8 and distinguish between better (more useful) information and inferior (less useful) information. These qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision usefulness of information. The two fundamental qualities that make

accounting information useful for decision making are relevance and faithful representation. Case 2-10 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-11 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-12 The answer to this case requires a visit to the FASB’s home page at the time it is assigned. Case 2-13 During the early 2000s, the FASB noted that concerns were being expressed about the quality and transparency of accounting information. One of the main concerns was the increasing complexity of FASB standards. The Board concluded that much of the detail and complexity associated with accounting standards was the result of rule-driven implementation guidance, 30

which allows “accounting engineering” to get around the rules thereby allowing companies to circumvent the intent and spirit of the standards. Additionally, the FASB noted that its Conceptual Framework has not provided all of the necessary tools for resolving accounting problems. This deficiency was attributed to the fact the certain aspects of the Conceptual Framework are internally inconsistent and incomplete. As a result, the Board is considering the need to develop an overall reporting framework similar to International Accounting Standard No. 1. Such a framework would provide guidance on issues such as materiality assessments, going concern assessments, professional judgment, consistency and comparability. It would also allow few, if any, exceptions and fewer implementation guidelines. To illustrate the difference between rules based and principles based standards, the standard setting process can be viewed as a continuum ranging from highly rigid standards on one end to general definitions of economics-based concepts on the other end. For example, consider accounting for the intangible asset goodwill. An example of the extremely rigid end of the continuum is the previously acceptable practice: Goodwill is to be amortized over a 40 year life until it is fully amortized. This requirement leaves no room for judgment or disagreement about the amount of amortization expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, the requirement lacks relevance because it does not reflect the underlying economics of the reporting entity, which differ across firms and through time. At the opposite end of the continuum is the FASB’s new rule: Goodwill is not amortized. Any recorded goodwill is to be tested for impairment and if impaired, written down to its current fair value on an annual basis. This requirement necessitates the application of judgment and expertise by both managers and auditors. The goal is to record the economic deterioration of the asset, goodwill Case 2-14 At a joint meeting in Norwalk, Connecticut, on September 18, 2002, the FASB and the IASB both acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting (the Norwalk Agreement). The two boards pledged to use their best efforts to (1) make their existing financial reporting standards fully compatible as soon as is practicable and (2) coordinate their future work programs to ensure that once it is achieved, compatibility is maintained. The international convergence project has three major aspects: (1) the Financial Statement Presentation Project, (2) the Conceptual Framework Project, and (3) the Standards Update Project. Case 2-15 The purpose of the financial statement presentation project is to establish a standard that will guide the organization and presentation of information in the financial statements. The boards’ goal is to improve the usefulness of the information provided in an entity’s financial statements to help users make decisions in their capacity as capital providers Accordingly, as a part of the Norwalk Agreement, the FASB and IASB committed to (1) undertake a short-term project 31

aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards (IFRSs, discussed in Chapter 3; (2) remove other differences between IFRSs and U.S. GAAP that remained on January 1, 2005, through coordination of their future work programs; that is, through the mutual undertaking of discrete, substantial projects that both boards would address concurrently; (3) continue progress on the joint projects that they are currently undertaking; and (4) encourage their respective interpretative bodies to coordinate their activities. In April 2004, the FASB and IASB decided to combine their respective projects on the reporting and classification of items of revenue, expense, gains, and losses. This project was undertaken to establish a common, high-quality standard for the presentation of information in financial statements, including the classification and display of line items and the aggregation of line items into subtotals and totals. The goal is to present information in individual financial statements (and among financial statements) in ways that improve the ability of investors, creditors, and other financial statement users to 1. Understand an entity’s present and past financial position 2. Understand the past operating, financing, and other activities that caused an entity’s financial position to change and the components of those changes 3. Use that financial statement information, along with information from other sources, to assess the amounts, timing, and uncertainty of an entity’s future cash flows The project is being conducted in three phases. Phase A addresses what constitutes a complete set of financial statements and requirements to present comparative information. Phase B addresses the more-fundamental issues for presentation of information on the face of the financial statements, including 1. Developing principles for aggregating and disaggregating information in each financial statement 2. Defining the totals and subtotals to be reported in each financial statement (which might include categories such as business and financing) 3. Deciding whether components of other comprehensive income/other recognized income and expense should be recycled to profit or loss and, if so, the characteristics of the transactions and events that should be recycled and when recycling should occur 4. Reconsidering SFAS No. 95, “Statement of Cash Flows,” and IAS 7, Cash Flow Statements, including whether to require the use of the direct or indirect method Some preliminary decisions regarding the presentation of the financial statements have been published by the FASB. These decisions are discussed and illustrated in Chapters 6 and 7. Phase C addresses the presentation and display of interim financial information in U.S. GAAP, including 1. Which financial statements, if any, should be required to be presented in an interim financial report 2. Whether financial statements required in an interim financial report should be allowed to be presented in a condensed format, and if so, whether guidance should be provided related to how the information may be condensed 3. What comparative periods, if any, should be required to be allowed in interim financial reports and when, if ever, should twelve month-to-date financial statements be required or allowed to be presented in interim financial reports 4. Whether guidance for nonpublic companies should differ from guidance for public companies 32

The boards completed their deliberations on Phase A in December 2005. On March 16, 2006, the IASB published its Phase A exposure draft, “Proposed Amendments to IAS 1 Presentation of Financial Statements: A Revised Presentation.” The FASB decided to consider phases A and B issues together and therefore did not publish an exposure draft on phase A. After considering the responses to its exposure draft, the IASB issued a revised version of IAS No. 1 in September 2007 Chapter 3for a discussion of IAS No. 1). The revisions to IAS No. 1 affected the presentation of changes in equity and the presentation of comprehensive income, bringing IAS No. 1 largely into line with FASB Statement No. 130, Reporting Comprehensive Income (FASB ASC 220). In February 2006, the two boards reaffirmed their commitment to the process of convergence in a Memorandum of Understanding (MoU) and voiced the shared objective of developing highquality, common accounting standards for use in the world’s capital markets. The MoU outlines a road map for eliminating the reconciliation requirement for non-U.S. companies that use IFRSs and are registered in the United States (discussed in Chapter 3). The MoU maintains that trying to eliminate differences between standards is not the best use of resources; rather, new common standards should be developed. Convergence will proceed as follows: First, the boards will reach a conclusion about whether major differences in focused areas should be eliminated through one or more short-term standard-setting projects, and, if so, the goal was to complete or substantially complete work in those areas by 2008. Second, the FASB and the IASB will seek to make continued progress in other areas identified by both boards where accounting practices under U.S. GAAP and IFRSs are regarded as candidates for improvement. In November 2009 the IASB and the FASB published a progress report describing their plans for completing the major projects on the MoU. This plan included milestone targets for each project. To provide transparency and accountability regarding those milestones, the two boards committed to reporting quarterly on the progress on convergence projects and to making those reports available on their respective websites. Additionally, they committed to hosting monthly joint board meetings and to provide quarterly updates on their progress on convergence projects. These milestones are discussed within their topic areas throughout the text. In an effort to comply with the goals of the Norwalk Agreement, the FASB issued four new statements to bring U.S. GAAP into consistency with IFRSs (SFAS No.151 (superseded), SFAS No. 153 (superseded), SFAS No. 154 (FASB ASC 250-10), and SFAS No. 163 (FASB ASC 944). Additionally, it issued a revised SFAS No. 141 (FASB ASC 805). The IASB published new standards on borrowing costs (IAS No. 23 revised) and segment reporting (IFRS No. 8). Phase B is being conducted with the following principles in mind: Financial statements should present information in a manner that 1. Portrays a cohesive financial picture of an entity 2. Separates an entity’s financing activities from its business and other activities 3. Helps a user access the liquidity of an entity’s assets and liabilities 4. Disaggregates line items if that disaggregation enhances the usefulness of that information in predicting future cash flows 5. Helps a user understand • how assets and liabilities are measured. • the uncertainty and subjectivity in measurements of individual assets and liabilities. • what causes a change in reported amounts of individual assets and liabilities.

The project has adopted cohesiveness as a standard for assessing its ability to attain these principles. That is, each financial statement should contain the same sections and categories, and the classification of assets and liabilities will drive the classification of the related changes in the statement of cash flows and comprehensive income statements. This process is expected to obtain more clarity in the relationships between statements and to facilitate financial analysis. The Statements of Comprehensive Income, Financial Position, and Cash Flows will each contain a Business Section that reports operating activities and investing activities of the specific statement. For example, in the Statement of Comprehensive Income, the Business Section will contain operating income and expenses as well as investing income and expenses; in the Statement of Financial Position, the Business Section will report operating assets and liabilities and investing assets and liabilities. In addition to the Business Section, in three of the four statements (excluding the Changes in Equity Statement), a Financing Section is provided as well as a section on taxes and discontinued operations (net of taxes). Each financial statement will contain the two primary sections business and financing. The following guidelines were adopted for displaying the items in each section: 1. The business section should have two defined categories: operating and investing. These categories require an entity to make a distinction between business activities that are part of an entity’s day-to-day business activities (and the business activity generates revenue through a process that requires the interrelated use of the net resources of the entity) (operating category) and business activities that generate nonrevenue income (and no significant synergies are created from combining assets) (investing category). 2. The financing section will include items that are part of an entity’s activities to obtain (or repay) capital and consist of two categories: debt and equity (a change from their decisions in September). a. The debt category will include liabilities where the nature of those liabilities is a borrowing arrangement entered into for the purpose of raising (or repaying) capital. b. The equity category will include equity as defined in either IFRS or U.S. GAAP. Case 2-16 In October 2004, the FASB and IASB decided to add to their agendas a joint project to develop an improved and common conceptual framework that is based on and builds on their existing frameworks; that is, the IASB’s Framework for the Preparation and Presentation of Financial Statements and the FASB’s Conceptual Framework Project (CFP). The goal of this project is to create a sound foundation for future accounting standards that are principles based, internally consistent, and internationally converged. The boards also intend to improve some parts of the existing frameworks, such as recognition and measurement, as well as to fill some gaps in the frameworks. For example, neither framework includes a robust concept of a reporting entity. The project 1. Focuses on changes in the environment since the original frameworks were issued, as well as omissions in the original frameworks, to efficiently and effectively improve, complete, and converge the existing frameworks. 2. Gives priority to addressing and deliberating those issues within each phase that are likely to yield benefits to the boards in the short term; that is, crosscutting issues that affect a number of their projects for new or revised standards. Thus work on several phases of the project will be conducted simultaneously, and the boards expect to benefit from work being conducted on other projects. 3. Initially considers concepts applicable to private-sector business entities. Later, the boards 34

will jointly consider the applicability of those concepts to private sector not-for-profit organizations. Representatives of public sector (government) standard-setting boards are monitoring the project and, in some cases, are considering what the consequences of private sector deliberations might be for public-sector entities. The project is being developed in eight phases and has resulted in the release of Statement of Financial Accounting Concepts No. 8. The objectives and summary of the decisions reached for each phase of the project at the time this text was published are outlined in the following paragraphs. Objectives and Qualitative Characteristics Phase The aim of the Objectives and Qualitative Characteristics phase of Financial Reporting is to consider the following issues: • The objective of financial reporting • The qualitative characteristics of financial reporting information • The tradeoffs among qualitative characteristics and how they relate to the concepts of materiality and cost–benefit relationships As discussed above, in 2010, the FASB and IASB jointly published Chapters 1 and 3 of the CFP as SFAC No. 8. Definitions of Elements, Recognition and Derecognition Phase The objectives of the Elements and Recognition phase are to refine and converge the boards’ frameworks in the following manner: 1. Revise and clarify the definitions of asset and liability. The boards have agreed that the FASB and IASB definitions of these elements have several shortcomings and have tentatively agreed on the following working definitions: a. An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have. b. A liability of an entity is a present economic obligation for which the entity is the obligor. 2. Resolve differences regarding other elements and their definitions. The FASB Concepts Statements currently identify more elements than does the IASB Framework, and the two frameworks define differently those elements that are common. The boards’ approach will focus initially on converging and defining only those key elements that are defined today in the FASB and IASB Frameworks. Additionally, the boards will need to consider how to define elements that are not currently defined, such as comprehensive income. 3. Revise the recognition criteria concepts to eliminate differences and provide a basis for resolving issues such as derecognition and unit of account. Each board’s current framework describes specific recognition criteria, some of which are similar and some of which are different. Neither board’s frameworks contain criteria to determine when an item should be derecognized. The boards plan to revise their recognition criteria concepts to eliminate those differences and provide a framework for resolving derecognition issues. The boards’ current frameworks provide little or no guidance on how the unit of account should be determined. Although a discussion paper was expected to be issued in late 2010, it was not forthcoming at the time this text was published, and the project is currently inactive. Measurement Phase The objective of the Measurement phase is to provide guidance for selecting measurement bases that satisfy the objectives and qualitative characteristics of financial reporting. It consists of the following milestones: 35

• • •

Milestone I will inventory and defines a list of measurement basis candidates that might be used as a basis for measurement on financial statements. Milestone II will evaluate the basis candidates identified in Milestone I. Milestone III will draw conceptual conclusions from Milestones I and II, while addressing practical issues.

• During its deliberations of Milestone I, the boards addressed the following five issues: 1. What are the measurement basis candidates? The boards agreed to a list of nine candidates: past entry price, past exit price, modified past amount, current entry price, current exit price, current equilibrium price, value in use, future entry price, and future exit price. 2. How are the measurement bases defined? The boards agreed to provide two definitions for each candidate—one from the perspective of an asset and one from the perspective of a liability. They further decided to focus on the concepts behind entry and exit prices, without respect to the way they are measured. 3. What are the basic properties of the measurement bases? The boards concluded that most candidates are either prices or values and that each candidate provides information primarily about a specific time frame. 4. Are the measurement issues appropriate for both assets and liabilities? The boards concluded that all the candidates were appropriate for use with assets and liabilities. 5. Should any measurement basis candidates be eliminated from consideration for evaluation in Milestone II? The boards agreed not to eliminate any of the nine candidates identified at the end of Milestone I. However, they did eliminate some other candidates in the earlier stages of Milestone I deliberations. Although a discussion paper was expected to be issued in late 2010, it was not forthcoming at the time this text was published, and the project is currently inactive. Reporting Entity Concept Phase The objective of the Reporting Entity phase is to determine what constitutes a reporting entity for the purposes of financial reporting. On March 11, 2010, the boards issued an exposure draft titled Conceptual Framework for Financial Reporting: The Reporting Entity (ED). This document notes that the objective of general-purpose financial reporting is to provide financial information about reporting entities that is useful in making decisions about providing resources to the entity and in assessing whether the management and the corporate officers of that entity have made efficient and effective use of the resources provided. The ED defines a reporting entity as a circumscribed area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders, and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether management and the corporate officers of that entity have made efficient and effective use of the resources provided. The ED noted that a reporting entity has three features: 1. Economic activities of an entity are being conducted, have been conducted, or will be conducted. 2. Those economic activities can be objectively distinguished from those of other entities and from the economic environment in which the entity exists. 3. Financial information about the economic activities of that entity has the potential to be useful in making decisions about providing resources to the entity and in assessing whether the management has made efficient and effective use of the resources provided. 36

As a result, identifying a reporting entity in a specific situation requires consideration of the boundary of the economic activities that are being conducted, have been conducted, or will be conducted. The existence of a legal entity is neither necessary nor sufficient to identify a reporting entity. A reporting entity can include more than one entity, or it can be a portion of a single entity. The ED also notes a single legal entity that conducts economic activities and does not control any other entity is likely to qualify as a reporting entity and that most, if not all, legal entities have the potential to be reporting entities. However, a single legal entity may not qualify as a reporting entity if, for example, its economic activities are commingled with the economic activities of another entity and there is no basis for objectively distinguishing their activities. But a portion of an entity could qualify as a reporting entity if the economic activities of that portion can be distinguished objectively from the rest of the entity and financial information about that portion of the entity has the potential to be useful in making decisions about providing resources to that portion of the entity. For example, a potential equity investor could be considering a purchase of a branch or division of an entity. Comments on this exposure draft were to be received by July 11, 2010. During its November 19, 2010 Joint Board Meeting, the Boards discussed some of the issues raised in comment letters on the ED and concluded that significant time will be required to satisfactorily address those issues. Owing to the priority placed on other projects, the Boards concluded that they could not devote the time necessary to properly address those issues in the near future. The FASB and IASB discussed some of the issues raised in the comment letters on the Exposure Draft and concluded that significant time would be required to satisfactorily address those issues. Because of the priority placed on other projects, the Boards concluded that they could not devote the time necessary to properly address those issues in the near future, and the project is currently inactive Boundaries of Financial Reporting, and Presentation and Disclosure Phase An objective of the Presentation and Disclosure, including Financial Reporting Boundaries, phase is to determine the concepts underlying the display and disclosure of financial information and to identify the boundaries of such information that will achieve the objective of generalpurpose financial reporting. This phase is currently inactive. The boards have not yet deliberated or made decisions regarding concepts for financial presentation and disclosure of financial information. Purpose and Status of the Framework Phase The objective of the Purpose and Status of the Framework phase is to consider the framework’s authoritative status in the GAAP hierarchy. The goal is to develop a framework that is of comparable authority for the use of both boards in the standard-setting process. At present, there are differences in the status of the boards’ existing frameworks. For an entity preparing financial statements under International Financial Reporting Standards, the IASB’s Framework provides guidance when there is no standard or interpretation that specifically applies to a transaction or other event or condition, or that deals with a similar and related issue. In those situations, the entity’s management is required to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. Under U.S. GAAP, the FASB’s Concepts Statements have a much lower status— they are ranked no higher than accounting textbooks, handbooks, and articles and are ranked below widely recognized and prevalent general or industry practices. 37

The FASB has decided that the authoritative status of the framework within the U.S. GAAP hierarchy should be considered once the framework is more substantially complete. However, for the purposes of providing comments on documents issued by the boards, respondents will be asked to assume that the framework’s authoritative status will be elevated in the U.S. GAAP hierarchy to have a status comparable to the IASB’s current Framework. The FASB and the IASB agreed that each board, within the context of its current GAAP hierarchy, will finalize the common framework as parts are completed and that later parts may include consequential amendments to earlier parts. The boards noted that the decision of how to finalize the joint framework might need to be readdressed when the boards discuss the placement of the framework within the IASB and FASB hierarchies. This phase of the Conceptual Framework Project is currently inactive. Application of the Framework to Not-for-Profit Entities Phase The objective of this phase of the Conceptual Framework Project is to consider the applicability of the concepts developed in earlier phases to not-for-profit entities in the private sector. This phase is currently inactive. The boards have not yet deliberated or made decisions regarding the applicability of particular concepts to not-for-profit entities. Remaining Issues, If Any, Phase The objective of the Remaining Issues phase is to consider remaining issues that have not been addressed by the previous seven phases. This phase is currently inactive. The boards will not deliberate or make decisions regarding final issues until the first seven phases are complete. Standards Update Project The FASB and IASB are also working on a number of individual standard issues, such as discontinued operation, financial instruments, fair value measurements, comprehensive income, consolidations, leases, revenue recognition, earnings per share, income taxes, and postretirement benefits. The overall objective of the standards update project is to make FASB and IASB standards more comparable. In April 2011, the FASB and IASB issued a joint statement on the progress archived in the standards update program. The boards reaffirmed the changes made to the work plan in June 2010 to allow broad-based and effective stakeholder outreach, which they believe is critical to the quality of the standards. That plan gave priority to the major MoU projects for which they believed the need for improvement of IFRSs and U.S. GAAP is the most urgent. Those priority projects include the joint projects on financial instruments, revenue recognition, leasing, insurance contracts, the presentation of other comprehensive income, fair value measurement, and the consolidation of investment companies. In addition, the IASB also assigned priority to improved disclosures about derecognized assets and other off–balance sheet risks (aligning with recently issued U.S. GAAP requirements) and consolidations (particularly in relation to structured entities). The boards also provided a report on the progress of their joint convergence work that stated the FASB and the IASB have taken the following actions: 1. Completed five projects: The boards have reached important decisions on a number of projects, reducing the number of remaining priority MoU projects to three (revenue recognition, leasing, and financial instruments) for continued work. Reflecting the completion of MoU projects, publication of standards that are converged or substantially converged on fair value measurement, consolidated financial statements (including 38

disclosure of interests in other entities), joint arrangements, other comprehensive income, and postemployment benefits was expected in the near future. 2. Priority given to the remaining MoU areas and insurance accounting: In November 2010 the boards decided to give priority to their joint work on three MoU projects— financial instruments, revenue recognition and leases—and accounting for insurance contracts in order to permit timely completion. 3. Extended the completion target beyond June 2011: At their meeting in April, the boards extended the timetable for the remaining priority MoU convergence projects and insurance beyond June 2011 to permit further work and consultation with stakeholders. The boards revised their work plan to focus on completing the three remaining priority convergence projects in the second half of 2011, in a manner consistent with an open and inclusive due process. For insurance contracts, the IASB planned to complete its project in the second half of 2011, and the FASB plans to issue an exposure draft in a similar timeframe. 4. Agreed that the decisions that will be made on effective dates will give entities sufficient time to implement changes: The boards have emphasized that they will set effective dates that will allow those who use IFRSs and U.S. GAAP adequate time to prepare for implementation of the standards. The boards also indicated that with the progress made since their last report, they are approaching the completion of their MoU program. Specifically: • The short-term projects identified for action in their 2006 MoU and updated 2008 MoU have been completed or are close to completion. • Of the longer-term projects, only three of the priority convergence projects remain for which the boards have yet to finalize the technical decisions—financial instruments, revenue recognition and leasing. Finally, the boards outlined the priority and timing of the remaining convergence work indicating that in 2008 the boards set the target date of 30 June 2011 to finalize the MoU projects. However, at their meeting in April 2011 the boards agreed that they will need to spend additional time beyond June 2011 to complete this joint work. The boards stated that they will use the additional time to consult those affected by the proposed changes and work through concerns and issues being raised by stakeholders. Before each standard is issued, the boards will consider • whether reexposure is necessary; and • whether they have undertaken sufficient outreach on the proposed standard to assure the boards that the proposed standard is operational and will bring improvements to financial reporting. The optimism expressed in this communiqué was considerably dampened by subsequent statements by FASB and IASB officials. In December 2011 the heads of the U.S. and international accounting boards that have been working to resolve standards differences agreed that their current convergence process should be replaced by one that is more manageable and effective. Speaking at the AICPA National Conference on Current SEC and PCAOB Developments, FASB Chair Leslie Seidman said that side-by-side convergence is not the optimal model in the long run. She said FASB would like to work with the IASB to complete the current priority convergence projects on revenue recognition, leasing, financial instruments, and insurance. But she said indefinite convergence is not a viable option, politically or practically. Hans Hoogervorst, chair of the International Accounting Standards Board (IASB), spoke immediately after Seidman at the conference and echoed her sentiments. Hoogervorst said the 39

IASB’s convergence history with FASB has been extremely useful in bringing IFRS and U.S. GAAP closer together. But he said that two boards of independently thinking professionals sometimes simply reach different conclusion. Case 2-17 a. FASB’s Conceptual Framework should provide benefits to the accounting community such as: 1. Guiding the FASB in establishing accounting standards on a consistent basis. 2. Determining bounds for judgment in preparing financial statements by prescribing the nature, functions and limits of financial accounting and reporting. 3. Increasing users’ understanding of and confidence in financial reporting. b. The most important quality for accounting information as usefulness for decision making. Relevance and faithful representation are the primary qualities leading to this decision usefulness. Usefulness is the most important quality because, without usefulness, there would be no benefits from information to set against its costs. c. There are a number of key characteristics or qualities that make accounting information desirable. The importance of three of these characteristics or qualities is discussed below. Understandability—information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it, or who misuse it. Relevance—the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations (including is material). Faithful representation—the faithful representation of a measure rests on whether the numbers and descriptions matched what really existed or happened, including completeness, neutrality, and free from error. (Note to instructor: Other qualities might be discussed by the student, such as enhancing qualities. All of these qualities are defined in the textbook).

Financial Analysis Case The solutions to the financial analysis depend upon the company and year selected.

CHAPTER 3 Case 3-1 The greatest advantage attributed by advocates of the harmonization of accounting standards is that international financial information would be comparable. Consequently, the concerns about the reliability of foreign financial statements would be alleviated ;and the free flow of international investments would be enhanced. Harmonization is also seen as resulting in improved risk analysis which would result in the lowering of interest rates. Another advantage is that the time and money now spent to consolidate divergent financial information would be saved. Presently, many adjustments, often arbitrary and sometimes base on faulty assumptions are needed. A third advantage would be the tendency for accounting standards to be raised to the highest level to be consistent with local economic, legal and social conditions. This is seen as overcoming the presently deficient accounting information presently supplied by developing economies. Critics of harmonization hold that it is neither practical or perhaps even valuable. They point to the spotty record of domestic standard setters in the United States where they are well-funded and widely supported. They also argue that a well developed global capital market already exists and has evolved without uniform accounting standards; consequently, there is no compelling need to harmonize standards. Other critics indicate that widespread cultural differences, especially language, make harmonization an almost impossible goal. Finally, some individuals feel that the issue of legal enforcement of standards may be an insurmountable problem Case 3-2 a.

A company may take different approaches in preparing financial statements for users in foreign companies. These are as follows: 1. Send the same set of financial statements to all users (domestic or foreign). This is, in essence, a do nothing approach, and puts the entire burden of understanding the financial reports on the user. On the other hand, if a company raises very little capital outside its home country, the added expense of taking another approach may not be worthwhile. Also, some companies using foreign investment may sell directly to sophisticated users who are able to use the unadjusted financial statements such as pension funds. 2. Translate the financial statements sent to foreign users into the language of the foreign nation's users. This is termed convenience translation and is a relatively inexpensive method of accommodation of foreign users. The user is saved the inconvenience of dealing with a 41

foreign language, but still must understand another country's accounting practices and monetary unit. This is a low-cost alternative to the do nothing approach. 3. Translate the financial statements sent to foreign users into the foreign nation's language and currency. This is termed preparing convenience statements. Although this process makes the statements easy for foreign users to read, it may mislead them into believing that the statements were prepared using the foreign country's accounting principles. 4. Prepare two sets of financial statements, one using the home country language, currency and accounting principles, the second using the language, currency and accounting principles of the foreign countries users. This is a large step in the direction of accommodating foreign users and should only be considered when the perceived benefits exceed the costs. 5. Prepare one set of financial statements based on worldwide accepted accounting principles. This is a utopian approach. At the present time there are no worldwide accepted accounting standards. This approach can only be taken if international accounting standards are harmonized. b.

No correct answer. Asks for an opinion.

Case 3-3 a.

The IASB was formed to develop worldwide accounting standards. In 2001 it was replaced by the International Accounting Standards Board. Its purpose was to develop worldwide accounting standards.

The IASC attempts to achieve its objectives through the formulation and publication of accounting standards to be observed in the presentation of financial statements. The IASC also attempts to use its membership in achieving its objectives. It attempts to promote the worldwide acceptance and observance of the accounting standards that it publishes. The members of the IASC agree to support the standards and to use their best endeavors to ensure that published financial statements comply with the standards, to ensure that auditors enforce the standards, and to persuade governments, stock exchanges and other bodies to support the standards. However, the IASC has no enforcement authority and must rely on the "best endeavors" of its members.

Case 3-4 a.

The IASC’s Framework for the Preparation of Financial Statements describes qualitative characteristics as the attributes that make the information provided in financial statements useful. The following four principal qualitative characteristics were defined. Understandability - Information should be provided so that individuals with a reasonable knowledge of business and economic activities and accounting and an willingness to study the information are capable of using it. Never-the-less, complex information should not be withheld because it is too difficult for some users to understand. Relevance - Information is relevant when it influences the economic decisions of users by helping them evaluate past present or future events or by confirming or correcting their past evaluations. Relevance is also affected by materiality. 42

Reliability - Information is reliable when it is free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent. As a consequence, events should be accounted for and presented in accordance with their substance and economic reality not merely their legal form. Comparability - Users must be able to compare an enterprise's performance over time, and to make comparisons with the performance of other enterprises. The framework also recognized that timeliness and the balance between benefits and costs were constraints on providing both relevant and reliable information. b.

The qualitative characteristics identified by the FASB Conceptual Framework in SFAC No. 8 were described as a hierarchy of accounting qualities. As such they were more specific than those identified by the IASC.

Case 3-5 a.

SFAC 8 defines comparability as the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items Making comparisons is normally a quantitative assessment of those characteristics. Such comparisons are valid only if the measurements used reliably represent the characteristic that is being compared. Moreover, comparability cannot be achieved without consistency of inputs and classification. Comparability can refer to comparisons across time or between or among business entities. The usefulness of accounting information of an enterprise is greatly enhanced when it can be compared to similar information of another enterprise or to similar information of the same enterprise for some other reporting period. The purpose of making such comparisons is to detect and explain similarities or differences. The financial statements of a U.S. company’s operating in a foreign country, which allowed fixed assets to be valued on balance sheets at current value, would not be comparable to the financial statement of companies in those countries. Comparability implies that measurements of two companies being compared to each other be made in the same way. It would be difficult to directly compare the fixed assets of a company that measures the assets at historical cost with one that measures fixed assets at current value.

The user should be able to rely upon accounting information. Accounting information is reliable when users can depend on it to represent the economic conditions and circumstances it purports to represent. Reliability implies that the accounting information is representationally faithful, verifiable, and neutral. According to SFAC No. 8, faithful representation is correspondence or agreement between a measure or description and the phenomenon it purports to represent. Accounting phenomena to be represented and reported are economic resources and obligations and the transactions and events that change those economic resources and obligations. Verifiability means that several measurers are likely to obtain the same measure. This quality contributes to the usefulness of accounting information because verification should provide a significant degree of assurance that accounting measures represent what they purport to represent. It is successful in minimizing measurer bias, but not necessarily measurement bias. 43

As a result, verifiability does not guarantee that amounts reported are in fact representationally faithful because verification cannot guarantee the appropriateness of the accounting method selected. It can only guarantee consensus among different measurers. Neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility. Amounts reported for property plant and equipment would be more reliable. Current cost requires estimates and some educated guesswork, particularly with regard to fixed assets which do not have a ready resale market. Historical cost based amounts rely on historical transactions which provide objective balance sheet measures. Although some discrepancies may still occur between different measurers due to estimating useful life or salvage value, and even different accounting approaches to cost allocation, the historical cost based amounts have greater reliability because they are verifiable and objectively determined. c.

Relevant accounting information is capable of making a difference in a decision by facilitating user predictions about outcomes of past, present, and future events or by confirming or correcting expectations. Hence, relevant information has predictive and feedback value. Moreover, to be relevant to the decision at hand, the information must be timely. It must be provided when it is needed. Thus, timeliness is an ancillary aspect of relevance because information needs to be available to the decision-maker before it loses its capacity to influence decisions. The student could argue for either approach as being relevant. Current cost would be relevant in evaluating a company from a physical capital maintenance perspective. It would provide a measure of what it would cost to replace the physical capacity of existing assets. Alternatively, the student could argue that historical information is more objective and reliable and provides information consistent with the stewardship function of accounting and the financial capital maintenance concept of income.

Case 3-6 a.

Since General Motors and Ford use LIFO, inventory in their balance sheets will reflect old costs. These costs will not represent recent costs and could be many years old. As a result, it could be argued that these balance sheet figures in no way purport to reflect the status of these resources at the balance sheet date and hence are useless for investor decision-making. On the other hand, Honda and Daimler-Benz use FIFO. Their inventory balances would reflect recent purchase prices which would more closely reflect the current value of the inventory at the balance sheet date. Although these values would be based on cost, they would be closer to replacement cost than what would be reported under LIFO and hence more relevant to decisions regarding the financial status of the enterprise.

If two estimates of an amount that is to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate. As a result, accountants tend to recognize losses more often than gains. 44

Under the assumption that price rise rather than fall, General Motors, Chrysler, and Ford provide more conservative accounting information as it relates to inventory. Each of these companies uses LIFO. LIFO matches recent, higher costs with revenues, resulting in lower reported profits and lower asset values that Honda and Daimler-Benz. However, in recent years this conclusion is tempered by the incidence of relatively low inflation. FASB ASC 3-1 Search “Generally accepted accounting standards” 105-10-05 Indicates that IASB standards are not presently considered GAAP

FASB ASC 3-2 Information on stock compensation is contained in FASB ASC 718-10-S99. It is accessed through the share based payment topic Room for Debate Debate 3-1 Team 1 According to the conceptual framework, financial statements should be relevant, reliable, comparable, and understandable. Investors should be able to understand the financial information of companies that operate in foreign countries. They should be able to compare the financial results across international boundaries. If companies throughout the world prepare financial statements using the same, or at least similar accounting principles and practices, comparability will be among companies would be greatly enhanced. Moreover, the investor would better understand financial results if companies use similar, and internally consistent accounting approaches. Both US GAAP and the IASB define assets as having probable future benefit and as resources that are controlled by the entity. Even though we don’t agree that the assets of one entity should be reported by another entity if we cannot control through our voting rights, consolidation of those assets of controlled entity would provide comparability internationally. Improved decision making would occur because it would no longer be necessary to interpret foreign financial statements and because comparability would be improved. Also, if the US were to increase harmonization of their accounting standards with the IASB, due to its statue as a world leader, economically and otherwise, it would aid in the IASB’s efforts to promote worldwide acceptance and observance of international accounting standards. The result would be an enhanced general acceptability of international accounting standards. If general acceptance and use of international accounting standards is increased in other countries, the result would be not only enhanced comparability, but increased transparency of financial reporting worldwide. Moreover, the increase transparency would provide more relevant information for user decision making. Reliability would also be enhanced because more preparers would conform to accounting practices, based on acceptable, unbiased measurement methods. 45

Team 2 We do not believe that harmonization of accounting standards should be the paramount consideration when setting accounting standards. Accounting standards should be based on the U.S. conceptual framework. According to the conceptual framework, financial statements should be understandable, reliable, relevant, and as a result, aid investors to make better decisions. If an international accounting standard does not meet those criteria, it should not be adopted by the US. In other words, harmonization should not be our primary goal, providing relevant, transparent financial statements should be. We do not believe that a company should report assets that it does not control by exercise of voting rights. An investee company is a separate legal entity. Even though its decision making may be influenced by a large minority stockholder, that stockholder can be over-ruled by the majority. If so, the stockholder does not, in fact, maintain control over the assets of the investee company and those assets do not meet the definition of providing future benefit to the minority investor because their use may not benefit the minority investor. If so, those assets not only will not meet the conceptual framework’s definition of an asset, consolidating those assets on the parent company balance sheet would result in reporting items that are not representationally faithful. Thus, the resulting consolidated balance sheet could not be viewed as containing items, all of which are relevant to users. WWW Case 3-7 a.

The SEC’s rationale for this decision was to foster the adoption of a set of globally accepted accounting standards.

An American Accounting Association committee concluded that eliminating the reconciliation requirement was premature. The committee noted that the decision to eliminate the 20-F reconciliation requirement for a subset of foreign-private issuers must be based on at least one of the following premises: 1. U.S. GAAP and IFRS are, at a minimum, informationally equivalent sets of accounting principles, or 2. Investors can reconstruct consistent and comparable U.S.-GAAP-based summary accounting measures from IFRS financial statements. The committee noted the following points in support of its conclusion: 1. Material reconciling items exist between U.S. GAAP and IFRS and the reconciliation currently reflects information that participants in U.S. stock markets appear to impound into stock prices. 2. In international contexts, U.S. GAAP and IAS/IFRS appear to possess information attributes of high-quality accounting standards _e.g., value relevance or mitigation of information asymmetry; however, U.S. GAAP appears to be preferred by U.S. investors. 3. Cross-country institutional differences will likely result in differences in the implementation of any single set of standards. Thus, IFRS may be a high-quality set of reporting standards pre-implementation but the resulting, published financial statement information could be of low quality, given inconsistent cross-border implementation practices. 46

4. Legal and institutional obstacles inhibit private litigation against foreign firms in the United States, and the SEC rarely undertakes enforcement actions against cross-listed firms. In the absence of a reliable enforcement mechanism, even high-quality accounting standards can yield low-quality financial reporting. 5. Differential implementation of standards across countries and differential enforcement efforts directed toward domestic and cross-listed firms creates differences in financial reporting even with converged standards. Whether the required reconciliation mitigates differences in implementation or improves compliance is an open issue; however, the SEC should understand the role of the reconciliation in mitigating differences in implementation and compliance before it is eliminated. 6. Despite the cost associated with preparing the reconciliation and satisfying the other listing requirements, evidence suggests that non-U.S. firms garner financial benefits from listing on U.S. exchanges and that the net benefits of a U.S. listing have not been eroded in recent years. 7. Harmonization of accounting standards could be beneficial to U.S. investors if it yields greater comparability and if IFRS provides information U.S. investors prefer for their investment decisions. Harmonization appears to be occurring via the joint standard-setting activities of the FASB and the IASB; thus, special, statutory intervention by the SEC appears to be unnecessary. Case 3-8 The IASB and FASB frameworks are quite similar. This may be partly attributable to the fact that the IASB framework was adopted sometime after the FASB developed most of its framework Specific similarities include that both frameworks adopt similar definitions for assets and liabilities and define equity as the residual of assets minus liabilities. Some differences with regard to the elements are that the IASB defines just five elements without specific definitions for Investments by and Distributions to Owners or Comprehensive Income. The IASB’s framework terms inflows of assets income rather than revenue. Finally, there is no distinction in the IASB framework between gains and revenues and losses and expenses. Case 3-9 The solution for this case requires a review of the IASC’s webpage at the time it is assigned. Financial Analysis Case The answer to this case depends on the company selected.

CHAPTER 4

Case 4-1 Investors wish to use accounting information to minimize risk and to maximize returns. The capital asset pricing model (CAPM) is an attempt to deal with both risks and return. The rate of return to an investor from buying a common stock and holding it for a period of time is calculated by adding the dividends to the increase (or decrease) in value of the security during the holding period and dividing this amount by the purchase price of the security or dividends + increase (or - decrease) in value purchase price Some risk is peculiar to the common stock of a particular company. For example, a company's stock may decline in value because of the loss of a major customer such as the loss of Hertz as a purchaser of rental cars by the Ford Motor Company. On the other hand, overall environmental forces cause fluctuations in the stock market that impact on all stock prices such as the oil crisis in 1974. These two types of risk are termed unsystematic risk and systematic risk. Unsystematic risk is that portion of risk peculiar to a company that can be diversified away. Systematic risk is the nondiversifiable portion which is related to overall movements in the stock market and is consequently unavoidable. As securities are added to a portfolio unsystematic risk is reduced. Empirical research has demonstrated that unsystematic risk is virtually eliminated in portfolios of 30-40 randomly selected stocks. However, if a portfolio contains many common stocks in the same or related industries, a much larger number of stocks must be acquired. An additional assumption of the CAPM is that investors are risk averse; consequently, investors will demand additional returns for taking additional risks. As a result, high risk securities must be priced to yield higher expected returns than lower risk securities in the marketplace. A simple equation can be illustrated to express the relationship between risk and return. This equation uses the risk free return (the Treasury Bill rate) as its foundation and is stated: Rs = Rf + Rp Where: Rs = The expected return on a given risky security Rf = The risk free rate Rp = The risk premium Since investors can eliminate the risk associated with acquiring a particular company's common stock by acquiring diversified portfolios, they are not compensated for bearing unsystematic risk. And, since well diversified investors are only exposed to systematic risk, investors using the CAPM as the basis for acquiring their portfolios will only be subject to systematic risk. Consequently, the only relevant risk is systematic risk and investors will be rewarded with 48

higher expected returns for bearing market-related risk that will not be affected by company specific risk. The measure of the parallel relationship of a particular common stock with the overall trend in the stock market is termed Beta (β). β may be viewed as a gauge of a particular stock's volatility to the volatility of the total stock market. A stock with a β of 1.00 has a perfect relationship to the performance of the overall market as measured by a market index such as Dow-Jones Industrials or the Standard and Poor's 500 stock index. Stocks with a β of greater than 1.00 tend to rise and fall by a greater percentage than the market; whereas, stocks with a β of less than 1.00 are less likely to rise and fall than is the general market index. Therefore β can be viewed as a particular stock's sensitivity to market changes, and as a measure of systematic risk. Case 4-2 a.

In the supply and demand model, price is determined by (1) the availability of the product (price) and (2) the desire to possess that product (demand). The assumptions of this model are: 1. All economic units possess complete knowledge of the economy. 2. All goods and services in the economy are completely mobile and can be easily shifted within the economy. 3. Each buyer and seller must be so small in relation to the total supply and demand that neither has an influence on the price or demand in total. 4. There are no artificial restrictions placed on demand, supply, or prices of goods and services.

The securities market is considered the best example of the supply and demand model because stock exchanges provide a relatively efficient distribution system and information concerning securities is available through many different outlets.

The efficient markets hypothesis holds that the price of a security is determined by the purchaser's knowledge of available relevant information about that security. According to this theory, the market for securities can be described as efficient if it reflects all available information and reacts instantaneously to new information. The three forms of the efficient market hypothesis differ in their definitions of all available information as follows: Weak form Semi-strong form Strong form -

Available information consists of past price history of the security. Available information includes past price history and all other publicly available information. Past price history, all publicly available information and insider information.

Case 4-3 a. Calendar anomalies are related with particular time periods i.e. movement in stock prices from day to day, month to month, year to year etc. Following are examples of calendar anomalies:

Calendar anomalies 1. Weekend Effect:

2. 3.

Description Stock prices are likely to fall on Monday; consequently, the Monday closing price is less than the closing price of previous Friday. Turn-of-the-Month Effect: The prices of stocks are likely to increase on the last trading day of the month, and the first three days of next month. Turn-of-the-Year Effect The prices of stocks are likely to increase during the last week of December and the first half month of January January Effect: Small-company stocks tend to generate greater returns than other asset classes and the overall market in the first two to three weeks of January. For many years, it has been argued that value strategies outperform the market. Value strategies consist of buying stocks that have low prices relative to earnings, dividends, the book value of assets or other measures of value. Following are examples of value anomalies: Value anomalies Description Low Price to Book Stocks with low market price to book value ratios generate greater returns than stocks having high book value to market value ratios. High Dividend Yield Stocks with high dividend yields tend to outperform low dividend yield stocks. Low Price to Earnings (P/E) Stocks with low price to earnings ratios are likely to generate higher returns and outperform the overall market, while the stocks with high market price to earnings ratios tend to underperform the overall market. Neglected Stocks Prior neglected stocks tend to generate higher returns than the overall market in subsequent periods of time. While the prior best performers tend to underperform the overall market.

Technical analysis is a general term for a number of investing techniques that attempt to forecast security prices by studying past prices and other related statistics. Common technical analysis techniques include strategies based on relative strength, moving averages, as well as support and resistance. Following are examples of technical anomalies Technical anomaly Description 1. Moving Average A trading strategy which involves buying stocks when short-term averages are higher than longterm averages and selling stocks when short-term averages fall below their long-term averages. 2. Trading Range Break A trading strategy which is based upon resistance and support levels. A buy signal is created when the prices reaches a resistance level. A selling signal is created when prices reach the support level. There are also several other types of anomalies that cannot be easily categorized. Examples of these anomalies are: Other Anomalies Description 50

1. The Size Effect 2. Announcement Based Effects and Postearnings Announcement Drift 3. IPO's, Seasoned Equity Offerings, and Stock Buybacks

4. Insider Transactions

5. The S&P Game

Small firms tend to outperform larger firms. Price changes tend to persist after initial announcements. Stocks with positive surprises tend to drift upward, those with negative surprises tend to drift downward. Stocks associated with initial public offerings (IPOs) in tend to underperform the market and there is also evidence that secondary offerings also underperform. Whereas, stocks of firms announcing stock repurchases outperform the overall market in the following years. There is a relationship between transactions by executives and directors in their firm's stock and the stock's performance. These stocks tend to outperform the overall market. Stocks rise immediately after being added to S&P 500

Behavioral finance explores the proposition that investors are often driven by emotion and cognitive psychology rather than rationale economic behavior. It suggests that investors use imperfect rules of thumb, preconceived notions, bias-induced beliefs and behave irrationally. Consequently, behavioral finance theories attempt to blend cognitive psychology with the tenets of finance and economics to provide a logical and empirically verifiable explanation for the often observed irrational behavior exhibited by investors. The fundamental tenet of behavioral finance is that psychological factors, or cognitive biases, affect investors, which limits and distorts their information and may cause them to reach incorrect conclusions even if the information is correct.

c. Some of the most the most common cognitive biases in finance are: Mental accounting - The majority of people perceive a dividend dollar differently from a capital gains dollar. Dividends are perceived as an addition to disposable income; capital gains usually are not. Biased expectations - People tend to be overconfident in their predictions of the future. If security analysts believe with an 80% confidence that a certain stock will go up, they are right about 40% of the time. Between 1973 and 1990, earnings forecast errors have been anywhere between 25% and 65% of actual earnings. Reference dependence - Investment decisions seem to be affected by an investor’s reference point. If a certain stock was once trading for $20, then dropped to $5 and finally recovered to $10, the investor’s propensity to increase holdings of this stock will depend on whether the previous purchase was made at $20 or $5 Representativeness heuristic. In cognitive psychology this term means simply that people tend to judge “Event A” to be more probable than “Event B” when A appears more representative than B. In finance, the most common instance of representativeness heuristic is that investors mistake good companies for good stocks. Good companies are well-known and in most cases fairly valued. Their stocks, therefore, may not have a significant upside potential. Case 4-4 51

The deductive approach to the development of a theory begins with the establishment of certain objectives. Once the objectives have been identified, key definitions and assumptions are stated. the researcher then develops a logical structure for accomplishing the objectives, based on the definitions and assumptions. Political economy theory is an example of deductive theory formation in that it stresses that the objective of accounting should not be the benefit of one group over another and recommends viewing market and socio-economic forces in the development of accounting theory. Agency theory is also a normative theory in that it attempts to explain behavior. The inductive approach to the development of a theory emphasizes making observations and drawing conclusions from those observations. It is going from the specific to the general. Under this approach the researcher generalizes about the universe based upon a number of observations of specific situations. APB Statement No. 4 was an example of inductive research in that it described GAAP on the basis of observations about current practice. The pragmatic approach to theory development is based on the concept of utility or usefulness. That is, once a problem has been identified, the researcher attempts to find a utilitarian but not necessarily a optimum solution. A Statement of Accounting Theory by Sanders, Hatfield and Moore was an example of the pragmatic approach to theory development in that it essentially recommended to accountants "do what you think best." This study was used by some accountants as an authoritative source that justified current practice. Case 4-5 The basic assumption of agency theory is that individuals maximize their own expected utilities. It attempts to explain behavior in terms of the benefit to be derived from a particular course of action. Inherent in agency theory is the assumption that there is a conflict of interest between the owners of a firm (shareholders) and the managers because managers are maximizing their own utilities which does not result in a maximization of shareholder wealth. An agency is defined as a relationship by consent between two parties whereby one party (agent) agrees to act on behalf of the other party (principal). According to agency theory, the political process has an impact on agency relationships because political officials frequently believe that inefficient markets can only be remedied by government intervention. Agency theory may help to explain the absence of a comprehensive theory of accounting because of the diverse interests involved in financial reporting; however, it will not help to identify the correct accounting procedures because it only attempts to explain the state of current practice not the best methods of practice. Case 4-6 Studies attempting to assess an individual's ability to use information are termed human information processing research. In general this research has indicated that individuals have a limited ability to process large amounts of information. The main consequences of this finding are: 1. An individual's perception of information is selective. That is, since individuals are capable of comprehending only a small part of their environment, their anticipation of what they expect to perceive about a particular situation will determine to a large extent what they do perceive. 52

2. Since individuals make decisions on the basis of a small part of the total information available, they do not have the ability to make optimal decisions. 3. Since individuals are incapable of integrating a great deal of information, they process information sequentially. If these conclusions are correct, the current focus on disclosure by the FASB may have an effect opposite to what is intended. That is, the annual reports may already contain more information than can be processed by individuals. Case 4-7 a.

Critical perspective research rejects the view that knowledge of accounting is grounded in objective principles. Rather researchers adopting this viewpoint share a belief in the indeterminacy of knowledge claims. This indeterminacy view rejects the notion that knowledge is externally grounded and is only revealed through systems of rules that are superior over other ways of understanding phenomena. These researchers attempt to interpret the history of accounting as a complex web of economic, political and accidental co-occurrences. They have also argued that accountants have been unduly influenced by one particular viewpoint in economics (utility based, marginalist economics). This economic viewpoint holds that business organizations trade in markets that form a part of a society's economy. Profit is the result of these activities and is indicative of the organization's efficiency in using society's scarce resources. In addition, these researchers maintain that accountants have also taken as given the current institutional framework of government, markets, prices and organizational forms with the result that accounting serves to aid certain interest groups in society to the detriment of other interest groups.

Critical perspective research views mainstream accounting research as being based upon the view that there is a world of objective reality that exists independently of human beings which has a determinable nature that can be observed and known through research. Consequently, individuals are not seen as makers of their social reality, instead they are viewed as possessing attributes that can be objectively described (i.e. leadership styles or personalities). The critical perspectivists maintain that mainstream accounting research equates normative and positive theory. That is, what is and what ought to be are the same. It is also maintained that mainstream accounting research theories are put forth as attempts to discover an objective reality, and there is an expressed or implied belief that the observed phenomena are not impacted by the research methodology. In summary, mainstream accounting research is based upon a belief in empirical testability.

In contrast, critical perspective research is concerned with the ways societies, and the institutions that make them up, have emerged and can be understood. Research from this viewpoint has been claimed to be based on three assumptions: 1. Society has the potential to be what it is not. 2. Conscious human action is capable of molding the social world to be something different or better. 3. No. 2 can be promoted by using critical theory.

Case 4-8 53

No. Financial reporting should be neutral. According to SFAC No. 5, neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility. Employers who provide postretirement and postemployment benefits presumably do so because the employees earned these benefits while they worked. If so, these costs accrue during the employment period. When they are accounted for, accrual or pay-as-you-go, does not affect the amount and timing of the future payments. Management decisions should be based on how they affect cash flows, i.e., their economic impact, not on how accountants report economic events.

Arguably, there are social costs associated with the accounting for postemployment and postretirement benefits. If management reacts to the accounting change be curtailing benefits, the cost is real and obvious. Employees will not receive benefits as they did before. Other possible costs might include agency costs such as management compensation or debt covenant agreements. If management’s compensation is based on net income, expensing the cost of providing these benefits early will reduce net income and management’s bonus. Reporting previously unreported liabilities for future benefit payments would negatively affect debt-toequity ratios that may be perceived by the stock market as increased risk and may violate existing debt covenant agreements.

Critical perspective proponents would argue that the social costs (see b.) outweigh the benefits, if any, of reporting postemployment benefits and postretirement benefits in accordance with the new pronouncements.

Mainstream accounting proponents would argue that the role of accounting is to report unbiased information. Accounting should report economic circumstances and events as they are and should not present information to achieve a particular result. They would argue that not to report the information required because of potential social costs would be to present financial information that was biased and thus not neutral, thereby violating the neutrality concept. They would also argue that the user needs to know the potential cost of these benefits and therefore reporting them in accordance with the new pronouncements is relevant to user decision making.

Case 4-9 a.

Liabilities are defined as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Capital leases meet this definition, hence they represent claims to resources. Liabilities are to be measured at the present value of future cash flows discounted at the effective rate of interest. This measurement requirement is consistent with the accounting of capital leases. Investors, creditors and other users recognize liabilities as requiring the use of cash in the future, hence, reporting liabilities at the present value of future cash flows provides information for user predictions of future cash outflows. While it is true that reporting the anticipated future cash flows in footnotes would also provide users with information to predict 54

future cash flows, simultaneous reporting of the present value of those future cash flows as a liability on the balance sheet underscores the fact that there is a present claim to company resources. Also, lease capitalization reports an asset that was essentially purchased. This treatment is consistent with that of other purchased assets. The leased asset provides the same services as a purchased asset. It will provide future benefit over its useful life or the lease term and hence meets the definition of an asset. Reporting its value as an asset meets the conceptual framework’s objective of providing information regarding a company’s resources. Simply listing the expected future lease payments in a footnote tends to obscure the fact that there is an asset and that the asset provides future benefit which presumably will be associated with future cash inflows. b.

The semi-strong form of the EMH implies that all publicly available information is impounded in security prices. Since the cash flows are the same whether the lease is capitalized or not, and those cash flows would be public information regardless of whether the lease were capitalized or described in the footnotes, the market would instantaneously impound the information into the stock prices in the same way under either accounting approach as soon as the information became public.

Agency theory would predict that managers would choose accounting procedures that would increase assets, increase earnings, or decrease debt. The higher debt is to equity the more likely the company will breach existing debt covenants. Management is expected to act in a manner that would reduce associated agency costs. Lease capitalization would increase assets, but it would also increase debt. Hence, agency theory would predict that management would have a tendency to structure lease agreements so that the debt would not be reported on the balance sheet - i.e., management would not want to capitalize leases.

FASB ASC 4-1 Employee Stock Options Information on stock compensation is contained in FASB ASC 718-10. It can be accessed through the expense topic field or by searching share based payments. Room for Debate Debate 4-1 The efficient market hypothesis and accounting information Team 1 Given the EMH, argue that accounting is relevant The three forms of the efficient market hypothesis (EMH) are the weak form, the semi-strong form, and the strong form. According to the weak form, the historical price of a stock provides an unbiased estimate of the future price of the stock. Hence, an investor cannot make excess gains by knowledge of prior prices. But, an investor could gain if he/she has other knowledge regarding expected future performance of a company, e.g., accounting information. Under this form of the EMH, accounting information is definitely relevant. According to the semi-strong form of the EMH, all publicly available information is instantaneously impounded into security prices. Hence, publicly available information, such as publicly released accounting information is already reflected in the price of a share of stock, and knowledge of this information would not provide an advantage to any potential investor. In this 55

case only insider information, e.g., accounting information which is not released to the public, would benefit the potential investor. Yet there are restrictions on insider trading of stocks. Nevertheless, insider information is still useful for other purposes. It is used for planning and strategy for the corporation. It is used in labor negotiations. It is used for the preparation of income tax returns. Many users use the information According to the strong form of the EMH, all information is impounded into security prices. Under this theory, even insiders could not benefit from knowledge of nonpublic information. But accounting information would still be useful to lenders, and a host of other users. Team 2 Given the EMH, argue that accounting information is irrelevant The three forms of the efficient market hypothesis (EMH) are the weak form, the semi-strong form, and the strong form. According to the weak form, the historical price of a stock provides an unbiased estimate of the future price of the stock. Hence, an investor cannot make excess gains by knowledge of prior prices. Under this form of the EMH it is not possible to argue that accounting information is irrelevant. An investor could gain if he/she has other knowledge regarding expected future performance of a company, e.g., accounting information. Under this form of the EMH, accounting information is definitely relevant. According to the semi-strong form of the EMH, all publicly available information is instantaneously impounded into security prices. Hence, publicly available information, such as publicly released accounting information is already reflected in the price of a share of stock, and knowledge of this information would not provide an advantage to any potential investor. If this is so, investors would not have information that is not publicly available and accounting information would be irrelevant. They could do just as well picking stock randomly. According to the strong form of the EMH, all information is impounded into security prices. No information, even accounting information which is not available to the public, would provide an advantage to any investor over other investors. Hence, accounting information would not be relevant. Debate 4-2 Critical perspective versus mainstream accounting Team 1 Present arguments supporting critical perspectives research. Critical perspectives proponents argue that accounting is not objective. Rather, the accounting procedures and standards resulted from a complex web of economic, political, and accidental cooccurrences. For example, the recent pronouncements related to accounting for fair value and accounting for stock options created pressure on Congress to interfere in the standard setting process. Similarly the pronouncement on loan impairments created outside pressures for the FASB to promulgate accounting rules taking the present value of future cash flows into consideration. The result is that debtors and creditors of impaired loans, in particular troubled debt restructures, account for the same economic event in different ways. It is difficult to explain how this kind of accounting asymmetry provides information that is representationally faithful and therefore objective. Critical perspectives proponents also argue that accounting has been unduly influenced by utility based, marginalist economics. That is, the profit motive is all that matters. This viewpoint 56

overlooks many other goals of business organizations, such as social goals. In addition they argue that accountants aid profit oriented groups to the detriment of others. Critical perspectives proponents view organizations in both a historic and a societal context. Accordingly, accounting should serve the good of society as well as business organizations. It should concern itself with the powerful multinational corporation and how these corporations affect the benefits received by and the costs to society. For example, accounting reports should provide information regarding the social costs of polluting the environment. Team 2 Arguments supporting traditional mainstream accounting research Traditional mainstream accounting research is concerned with unbiased, objective reporting of results of economic transactions and events. Accounting serves a stewardship function for investors, creditors and other users. Because the modern corporation is characterized by separation of management and ownership, accounting has a responsibility to owners to report how management has utilized the resources entrusted to it and how the company has actually performed during the accounting period. Accounting does have a duty to society. But, that duty is not to try to cause corporations to provide benefit to the society at large. Rather, in a free market economy, business serves society by providing goods and services to the public. In return, business provides a return to owners, jobs for societies people, and profits to other businesses by buying goods and services from them. It is the accountant's job to report on these activities so that users of accounting information can assess the value of the company. It is not the accountant’s job to pass judgment on the activities themselves or to bias reporting so that a societal goal can be reached. Debate 4-3 Positive versus normative accounting theory Team 1Support reliance on positive theory to develop a general theory of accounting Proponents of the positive theory of accounting maintain that it provides a description of existing accounting practice. In fact, this theory has arisen because existing theoretical constructs do not fully explain accounting practice. Stated differently, positive theory explains what is, rather than what should be. Thus, it can be used to explain why companies make the accounting choices that they do. Positive accounting can be associated with the contractual view of the firm in which accounting practices have evolved to mitigate contracting costs by establishing agreement among varying parties. For example, a positivist would say that conservatism has origins in the contract markets, including managerial compensation contracts and lender debt contracts. To prove their point, one would argue that, absent conservatism, managerial compensation agreements may reward managers based on current performance that may later prove unwarranted. According to Watts and Zimmerman, positive accounting theory should help us to better understand the sources of pressures that drive the accounting standard-setting process and how accounting standards affect individuals and individual behavior and thus the allocation of resources. According to the theory, managers of firms make accounting choices because of their own self interests. If we can better understand how accounting standards affect management, then we can do a better job of writing standards to help bring about appropriate, rather than 57

dysfunctional management behavior. If we don’t know how accounting standards will be used, then it is unlikely that the goals of transparency and better reporting will be achieved. Positive, not normative accounting theory, explains observed accounting practice. Unlike normative accounting theory it does not rely on consensus of accounting professionals. Because there is no set of goals that is universally accepted by accountants, normative accounting theory development may not provide appropriate, practical accounting standards. Thus, since normative accounting theories rely upon acceptability, the resulting theoretical development may be suspect. Team 2 1Support reliance on normative theory to develop a general theory of accounting Normative accounting theory is based on sets of goals which prescribe the way financial reporting should be, not just how it is. If we do not know what we should be reporting, how can we expect to develop accounting standards whose use will produce financial reports that can be relied upon to present the true financial picture of the reporting entity? Accountants typically agree with the Conceptual Framework’s goal of providing decisionrelevant financial information to users. Decision-relevant financial reports provide the user with information which they can use to predict future performance and to compare companies. Only accounting standards that are based on what ought to be are likely provide management with a consistent choice and application of accounting policies so that reported results are unbiased and transparent. Accounting standards derived from normative theory can result in financial statements that are consistent across time and among companies. Knowledge of how managers can use accounting information to bias financial results is useful, but does not provide accountants with what they need to prepare decision-relevant financials. Accounting standards should be based on clearly stated objectives that can be used to derive logical and consistent principles and practices. Just because there is no universally accepted set of objectives, does not mean that there should not be. There is, at least, a relatively wide acceptance of the underlying objectives and assumptions outlined in the FASB’s Conceptual Framework. These assumptions can certainly be relied upon to aid in the development of logical and consistent accounting standards. We can use these objectives and assumptions to logically derive accounting standards using a deductive approach. In other words, deduction, based on agreed upon assumptions, is an appropriate approach to accounting theory development. This is the normative approach. WWW Case 4-10 a.

Agency relationships involve costs to principals. Agency costs have been defined as the sum of (1) monitoring expenditures incurred by principals to control the behavior of agents, (2) bonding expenditures incurred by the agent, and (3) the residual loss. Monitoring expenditures include such costs as costs of measuring and observing the agent’s behavior and the costs of establishing compensation schemes that would tend to provide incentives to the agent to realign personal goals to be closer to those of principals. Bonding expenditures are incurred by the agent to guarantee that he will not take certain actions to harm principal’s interest or that he will compensate the principal if he does. The wealth effect caused by a difference between actions taken by the agent and what the principal would have the agent take. Because individuals are 58

expected to take actions to maximize their own utility, managers and shareholders are expected to incur monitoring and bonding costs as long as these costs are less than the residual loss. b.

An increase in debt would increase agency costs. An increase in debt would increase interest expense and lower income to stockholders. It would also increase the debt-to-equity ratio and thus would be perceived as increasing risk. Increase in risk may increase the cost of debt via increased interest rate.

To reduce risk, debt-holders often restrict the amount of debt a company can issue, by putting a limit on the company’s debt-to-equity ratio. The debt covenants are a bonding cost that reduce the cost of debt.

Case 4-11

The primary goal of accounting information is to provide investors with information that is relevant and faithfully represents economic phenomena so they can make informed investment decisions. Individual investors make the following investment decisions: • Buy—a potential investor decides to purchase a particular security on the basis of available information. • Hold—an actual investor decides to retain a particular security on the basis of available information. • Sell—an actual investor decides to dispose of a particular security on the basis of available information. Individual investors use all available financial information to assist in acquiring or disposing of the securities contained in their investment portfolios that are consistent with their risk preferences and the expected returns offered by their investments. One of the methods available to investors to make these decisions is fundamental analysis. Fundamental analysis is an attempt to identify individual securities that are mispriced by reviewing all available financial information. These data are then used to estimate the amount and timing of future cash flows offered by investment opportunities and to incorporate the associated degree of risk to arrive at an expected share price for a security. This discounted share price is then compared to the current market price of the security, thereby allowing the investor to make buy–hold–sell decisions. Case 4-12 The students will have different answers to this case depending on the companies selected and the time period chosen. Financial Analysis Case The students will have different answers to this case depending on the companies selected.

CHAPTER 5

Case 5-1 a.

Earnings management is the attempt by corporate officers to influence short-term reported income. It is believed that managers may attempt to manage earnings because they believe investors are influenced by reported earnings. The methods of earnings management include the use of production and investment decisions, and the strategic choice of accounting techniques (including the early adoption of new accounting standards). In most cases, earnings management techniques are designed to improve reported income effects; however, such is not always the case. An alternate explanation is the "Big Bath" theory which suggests that management may take the opportunity to report more bad news in periods when performance is low to increase future profits. An argument has also been made that management may choose to take large write-offs in periods when their performance is otherwise extremely positive.

Some methods that may be used by management to smooth earnings are: postponing end-of-theyear inventory replacement expenditures for merchandising companies, postponing the production of products for manufacturing companies, and the early adoption of new FASB accounting standards such as SFAS No. 109 when it has a positive effect on reported net income due to the recording of deferred tax benefits. Arthur Levitt, the former chair of the SEC, has outlined five earnings management techniques that he believes threaten the integrity of financial reporting 1. Taking a bath

The one-time overstatement of restructuring charges to reduce assets, which reduces future expenses. The expectation is that the one-time loss is discounted in the marketplace by analysts and investors who will focus on future earnings. 2. Creative acquisition accounting

Avoiding future expenses by one-time charges for in-process research and development. 3. “Cookie jar” reserves

Overstating sales returns or warranty costs in good times and using these overstatements in bad times to reduce similar charges. 4. Abusing the materiality concept

Deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant. 5. Improper revenue recognition 60

Recording revenue before it is earned. It was noted that over half of the SEC’s enforcement cases filed in 1999 and 2000 involved improper revenue recognition issues. Case 5-2 a.

A major purpose of income reporting is to allow investors to predict future cash flows. Despite the evidence that accounting earnings are good indicators of stock returns, the use of the transactions approach to income determination along with the principle of conservatism, and the materiality constraint; have led security analysts to the conclusion that economic income, rather than accounting income is a better predictor of future cash flows. Consequently, these individuals have suggested assessing the quality of earnings to predict future cash flows. Earnings quality is defined as the degree of correlation between a company's accounting income and its economic income. Several techniques have been developed to use in assessing earnings quality including: 1.

Compare the accounting principles employed by the company with those generally used in the industry and by competitions. Do the principles used by the company inflate earnings?

Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings.

Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods.

Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

Determine the replacement cost of inventories and other assets. generating sufficient cash flow to replace their assets?

Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.

Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales.

Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues.

Is the company

The answer to this part of the case is dependent upon the company selected. The students should be able to address all, or, at least, most of the above issues and reference the section of the annual report that contained the relevant information.

Case 5-3 a.

Income results from economic activity in which one entity furnishes goods or services to another. To warrant revenue recognition, the earning process must be substantially complete and 61

there must be realization--a change in assets that is capable of being objectively measured. Normally this involves an arm's length exchange transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice or may be stipulated in a contract. Events that give rise to revenue recognition are: the completion of a sale; the performance of a service; the progress of a long-term construction project, as in shipbuilding; and the production of a standard interchangeable good (such as a precious metal or an agricultural product) which has an immediate market, a determinable market value, and only minor costs of marketing. The passing of time may also be the event that establishes the recognition of revenues, as in the case of interest or rental revenue As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable, or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to reasonably estimate the related expenses. In such instances revenue recognition must be deferred until the matching process can be completed. b.

Bonanza, in effect, is a merchandising firm which collects cash (for stamps) far in advance of furnishing the goods. In addition, since the data indicates that about five percent of the stamps sold will never be redeemed, it also has revenue from this source unless the stamps escheat. Bonanza's revenues from these two sources could be recognized on one of three major bases. First, all revenue could be recognized when the stamps are sold--the sales basis or cashcollection basis if all sales are for cash. Secondly, amounts collected at the time stamps are sold could be treated as an advance (sometimes referred to as deferred or unearned revenue) until stamps are exchanged for the merchandise premiums at which time all of the revenue including that relating to the never-to-redeemed stamps could be recognized. Thirdly, some revenue could be recognized at the time of redemption--this treatment would be especially appropriate for approximately five percent of the total, the stamps that will never be redeemed. A modification of this basis would be to recognize the revenue from the never-to-be-redeemed stamps on a passage-of-time basis. The principal expense, merchandise premium costs, should be matched with the revenue. If all revenue is recognized when stamps are sold, and accrual of the cost of future premium redemptions would be necessary. In such a case, when stamp redemptions and related premium issuances occurred, the costs of the premiums would be charged to the accrued liability account. On the other hand, if stamp sales were treated as an advance, the deferred revenue would be recognized and the matching cost of the premiums issued would be recognized with the revenue at the time of redemption. Under the third alternative, some predetermined portion, at least, of the revenue from the never-to-be-redeemed stamps would be recognized when the stamps are sold, but the recognition of the merchandise premium expense would be deferred until time of redemption. Reasonable estimation is crucial to income determination. Under the first alternative it is necessary to estimate future costs of premium issuances well in advance of the actual occurrence. In the second case it is necessary to estimate the proportion of revenue which has already been earned on the basis of premium costs already incurred. It is a vital certainty that not all stamps sold will ultimately be presented for redemption. Such factors as the number of 62

stamps required to fill a book, the types of customers who receive stamps, and the ease of exchanging stamp books for premiums will all affect the proportion of stamps actually redeemed in relation to the potential redemptions. The difference between the five percent initial estimate and the actual proportion of unredeemed stamps affects the accrual of a liability for redemption of stamps issued under the first method and the rate of transfer of revenue from the advances account under the second and third methods. There will be other expenses aside from the costs of premiums issued but they should be relatively small after the initial promotion period and they should be accounted for under the usual principles which apply to accrual-basis accounting. Thus, premium catalogs printed but undistributed would ordinarily be treated as prepaid expenses; wages and salaries would be treated as expenses when incurred; depreciation, taxes, and similar expenses would be recognized in the usual manner. c.

Under all of the alternatives Bonanza's major asset (in terms of data given in the question) would be its inventory of premiums. Another inventory item, perhaps minor in amount, would be the cost of printing the stamps that were on hand awaiting sale to dealers. The major account with a credit balance would be either an estimated liability for cost of redeeming the outstanding stamps under the first alternative or an advance (deferred revenue) account under the second and third alternatives. In view of the nature of the operation, the inventory account(s) would be included in the current asset classification and the liability would be classified as current. The advances could be reported preferably as a current liability or possibly as deferred credit.

Case 5-4 a.

1. Cost is the amount measured by the current monetary value of economic resources given up or to be given up in obtaining goods and services. Economic resources may be given up by transferring cash or other property, issuing capital stock, performing services, or incurring liabilities. Costs are classified as unexpired or expired. Unexpired costs are assets and apply to the production of future revenues. Examples of unexpired costs are inventories, prepaid expenses, plant and equipment, and investments. Expired costs, which most costs become eventually, are those that are not applicable to the production of future revenues and are deducted from current revenues or charged against retained earnings. 2. Expense in its broadest sense includes all expired costs, i.e., costs which do not have any potential future economic benefit. A more precise definition limits the use of the term expense to the expired costs arising from using or consuming goods and services in the process of obtaining revenues, e.g., cost of goods sold and selling and administrative expenses. 3. A loss is an unplanned cost expiration and for this reason is often included in the broad definition of expenses. A more precise definition restricts the use of the term loss to cost expirations which do not benefit the revenue-producing activities of the firm. Examples include the unrecovered book value on the sale of fixed assets and the write-off of goodwill due to unusual events within an accounting period. The term loss is also used to refer to the amount by which expenses and extraordinary items exceed revenues during an accounting period. 63

i. Cost of goods sold is an expired cost and may be referred to as an expense in the broad sense of the term. On the income statement it is most often identified as a cost. Inventory held for sale which is destroyed by an abnormal casualty should be classified as a loss. ii. Bad debts expense is usually classified as an expense. However, some authorities believe that it is more desirable to classify bad debts as a direct reduction of sales revenue (an offset to revenue). A material bad debt which was not provided for in the annual adjustment, such as bankruptcy of a major debtor, may be classified as a loss. iii. Depreciation expense for plant machinery is a component of factory overhead and represents the reclassification of a portion of the machinery cost to product cost (inventory). When the product is sold, the depreciation becomes a part of the cost of goods sold which is an expense. Depreciation of plant machinery during an unplanned and unproductive period of idleness, such as during a strike, should be classified as a loss. The term expense should preferably be avoided when making reference to production costs. iv. Organization costs are those costs that benefit the firm for its entire period of existence and are most appropriately classified as a non-current asset. When there is initial evidence that a firm's life is limited the organizational costs should be allocated over the firm's life as an expense, or amortized as a loss when going concern foresees termination. In practice, however, organization costs are often written off in early years of a firm's existence. v. Spoiled goods resulting from normal manufacturing processing should be treated as a cost of the product manufactured. When the product is sold the cost becomes an expense. Spoiled goods resulting from an abnormal occurrence should be classified as a loss.

Period costs and product costs are usually differentiated under one of two major concepts. One concept identifies a cost as a period or product cost according to whether the cost expires primarily with the passage of time or directly for the production of revenue. The other concept identifies a cost as a product or a period cost according to whether or not the cost is included in inventory. Under the first concept period costs are all costs which expire within the accounting period and are only indirectly related to the production of revenue within the period and product costs are those costs associated with the manufacture of a firm's product and that generate revenue in the period of its sale. Some costs are easily associated with the production of revenue, such as the manufacturing or purchase cost of a product sold, and are designated as product costs. Other costs may be incurred as costs of doing business and are more difficult to relate to the production of revenue, such as general and administrative costs, and are classified as period costs. Costs which cannot be readily identified with the production of revenue in any particular period, such as the company president's salary which may produce revenue in many distant future accounting periods, are also classified as period costs because they cannot be specifically identified with any future accounting period. Under the second concept product costs include only the costs which are carried forward to future accounting periods in inventory and all expired costs are period costs.

Case 5-5 64

The point of sale is the most widely used basis for the timing of revenue recognition because in most cases it provides the degree of objective evidence accountants consider necessary to reliably measure periodic business income. In other words, sales transactions with outsiders represent the point in the revenue generating process when most of the uncertainty about the final outcome of business activity has been alleviated. It is also at the point of sale in most cases that substantially all of the costs of generating revenues are known, and they can at this point be matched with the revenues generated to produce a reliable statement of a firm's effort and accomplishment for the period. Any attempt to measure business income prior to the point of sale would, in the vast majority of cases, introduce considerably more subjectivity in financial reporting than most accountants are willing to accept.

.i. Though it is recognized that revenue is earned throughout the entire production process, generally it is not feasible to measure revenue on the basis of operating activity. It is not feasible because of the absence of suitable criteria for consistently and objectively arriving at a periodic determination of the amount of revenue to take up. Also, in most situations the sale represents the most important single step in the earnings process. Prior to the sale the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales. The accumulation of costs during production does not alone generate revenue; rather, revenues are earned by the entire process, including making sales. Thus, as a general rule the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition. Except in unusual circumstances, revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount. ii. To criticize the sales basis as not being sufficiently conservative because accounts receivable do not represent disposable funds, it is necessary to assume that the collection of receivables is the decisive step in the earning process and that periodic review measurement, and therefore net income, should depend on the amount of cash generated during the period. This assumption disregards the fact that the sale usually represents the decisive factor in the earning process and substitutes for it the administrative function of managing and collecting receivables. In other words, the investment of funds in receivables should be regarded as a policy designed to increase total revenues, properly recognized at the point of sale; and the cost of managing receivables (e.g., bad debts and collection costs) should be matched with the sales in the proper period. The fact that some revenue adjustments (e.g., sales returns) and some expenses (e.g., bad debts and collection costs) may occur in a period subsequent to the sale does not detract from the overall usefulness of the sales basis for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as not to detract from the reliability of reported net income. Thus, in the vast majority of cases for which the sale basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later point in time. c.i.

During production. This basis of recognizing revenue is frequently used by firms whose major source of revenue is long-term construction projects. For these firms the point of sale 65

is far less significant to the earning process than is production activity because the sale is assured under the contract, except of course where performance is not substantially in accordance with the contract terms. To defer revenue recognition until the completion of long-term construction projects could significantly impair the usefulness of the intervening annual financial statements because the volume of completed contracts during a period is likely to bear no relationship to production volume. During each year that a project is in process a portion of the contract price is therefore appropriately recognized as that year's revenue. The amount of the contract price to be recognized should be proportionate to the year's production progress on the project. It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured. ii. When cash is received. The most common application of this basis for the timing of revenue recognition is in connection with installment sales contracts. Its use is justified on the grounds that, due to the length of the collection period, increased warrant revenue recognition until cash is received. The mere fact that sales are made on an installment contract basis does not justify using the cash receipts basis of revenue recognition. The justification for this departure from the sales depends essentially upon an absence of a reasonably objective basis for estimation the amount of collection costs and bad debts that will be incurred in late periods. If these expenses can be estimated with reasonable accuracy, the sales basis should be used. Case 5-6 Statement of Financial Accounting Concepts No.5, "Recognition and Measurement in Financial Statements of Business Enterprises." does not suggest major changes in the current structure and context of financial statements. However, it did suggest that a statement of cash flows should replace the then required statement of changes in financial position (this change was subsequently adopted). In general, SFAC No. 5 attempts to set forth recognition criteria and guidance on what information should be incorporated into financial statements, and when this information should be reported. According to this Statement, a full set of financial statements for a period shows: 1. 2. 3. 4. 5.

Financial position at the end of the period. Earnings for the period. Comprehensive income for the period. Cash flows during the period. Investments by and distributions to owners during the period.

The statement of financial position should provide information about an entity's assets, liabilities, and equity and their relationship to each other at a moment in time. It should also delineate the entity's resource structure-major classes and amounts of assets-and its financing structure-major classes and amounts of liabilities and equity. The statement of financial position is not intended to show the value of a business, but it should provide information to users wishing to make their own estimates of the enterprise's value. 66

Earnings is a measure of entity performance during a period. It measures the extent to which asset inflows (revenues and gains) exceed asset outflows. The concept of earning provided in SFAC No. 5 is similar to net income for a period in current practice. However, it excludes certain adjustments from earlier periods now recognized in the current period. It is expected that the concept of earnings will continue to be subject to the process of gradual change that has characterized its development. Comprehensive income is defined as a broad measure of the effects of transactions and other events on an entity. It comprises all recognized changes in equity of the entity during a period from transactions except those resulting from investments by owners and distributions to owners. The relationship between earnings and comprehensive income is illustrated as follows. Revenues Less: Expenses Plus: Gains Less: Losses = Earnings

Earnings Plus or minus cumulative accounting adjustments Plus or minus other nonowner changes in equity = Comprehensive income

The statement of cash flows should directly or indirectly reflect an entity's cash receipts classified by major source and its cash payments classified by major uses during a period. The statement should include cash flow information about its operating, investing and financing activities. A statement of investments by and distributions to owners reflects an entity's capital transactions during a period, that is, the extent to which and in what ways the equity of the entity increased or decreased from transactions with owners. Case 5-7 a.

The matching concept associates efforts (costs) with accomplishments (revenues). Expenses are generally recognized when economic benefits are used up in delivering goods or producing services - i.e., revenues are earned. Expenses are defined in SFAC No. 6 as outflows or other using up as assets or incurrences of liabilities from producing goods or providing services, or rendering other activities that constitute the entity’s ongoing or central operations. This definition is consistent with the matching concept. The matching concept is important to income reporting because of the going concern assumption. Since business entities are presumed to be going concerns, enterprise performance must be assessed at intervals. That is, accountants must report periodically to investors, creditors and other users. Periodic reporting requires that accountants report on the performance of the entity during an accounting period so that users can assess enterprise how well the enterprise is utilizing resources to generate future cash flows for operations, reinvestment in operations, and dividends for investors.

Expenses, such as cost of goods sold, are directly linked to the production of revenue. These costs are matched directly to the revenue generated during the accounting period. Many expenses are associated with the period in which the revenue was generated. These costs 67

include such items as administrative salaries or electricity for the sales office. Other expenses are systematically allocated to the periods benefited by their use. For example, the cost of fixed assets is typically allocated to periods based on useful life. c.

According to SFAC No. 5, earnings and comprehensive income combined reflect the extent to which and the ways in which the equity (net assets) of an entity increased or decreased from all sources other than transactions with owners during the accounting period. Users need information about the causes of changes in net assets and how these changes affected ongoing operations. Direct measures of asset and liability balances at the end of the accounting period are linked to expense and revenue measurement because financial statements are articulated. The measurement of earnings using a balance sheet approach is consistent with the financial capital maintenance concept of income determination. This concept is critical to determining the return on invested capital. A return on capital occurs only if there has been an increase in net assets during the period exclusive of investments by and distributions to owners. Hence, financial capital maintenance and thus a balance sheet approach to income measurement is relevant to investor decision making.

The measurement of deferred income taxes uses the asset/liability approach. Under this approach the deferred tax asset and liability balances are determined. Income tax expense is equal to the current provision for income tax plus the change in the deferred tax asset and or liability balance. Aging of accounts receivable provides balance sheet measure of net realizable value. The resulting balance in the allowance account is used to measure the amount of bad debt expense in the income statement. Measures of cost of goods sold utilize a balance sheet approach. Typically, the cost of inventory is determined, then cost of goods sold is computed as a residual amount.

Case 5-8 a.

If two estimates of an amount that is to be received or paid in the future are about equally likely, the concept of conservatism dictates using the less optimistic estimate.

Conservatism has affected financial reporting because there is a tendency for accountants to recognize losses, but not gains. For example, loss contingencies are accrued when they are probable and the amount of the potential loss is reasonably estimable. Similar gain contingencies are not accrued. In accounting for sale-leasebacks where more than a minor portion is leased back, losses on sales are recognized; whereas, gains are deferred. Lower-ofcost-or-market is used for inventory whereby the carrying value of inventory is written down to market if it is lower, but not up to market if market is higher.

No. If an economic loss has occurred it should be reported. There is no reason that a similar occurrence for a gain should not also be reported. Accountants should report what has happened during the accounting period in an unbiased objective way. Gains happen as well as losses. If they are not also reported, the reporting of gains and losses in the income statement will not be what it purports to be.

No. Physical capital maintenance implies that earnings occur when the physical capacity exclusive of owner transactions increases during the accounting period. Physical capital is the replacement cost of a company’s net assets. Replacement cost can increase or decrease. Such a concept of earnings would recognize increases and decreases in current value (gains and losses) during the accounting. However, these changes would be considered capital maintenance adjustments, rather than earnings adjustments. Physical capital maintenance matches current cost with current period revenues. Holding gains and losses would be excluded from the income statement.

Yes and no. Financial capital maintenance basically accommodates any measure of asset value, whether or not conservative. Whatever measurements are used, changes in assets and liabilities would flow through the income statement. Nevertheless, an argument could be made that financial capital is maintained only if the measurements reflect the purchasing power of dollars invested in the company. If so, measures based on price level changes, specific or general could arguably be preferred to historical cost. If so, gains and losses should both be recognized.

FASB ASC 5-1 Revenue Recognition A search for revenue recognition resulted in over 90 different places in the FASB ASC where revenue recognition is discussed. FASB ASC 5-2 Recognition of Franchise Fee Revenue Accounting for franchise fee revenue is found at FASB ASC 952-605-25. It is found by searching franchise fee revenue. FASB ASC 5-3 Real Estate Sales The answer is found at FASB ASC 360-20-40-3 and FASB ASC 360-20-40-27 and can be found by searching for real estate sales.

FASB ASC 5-4 Current Value Search current value 274 Personal Financial Statements 10 Overall 05 Background FASB ASC 5-5 Accounting for Inflation Search inflation 255 Changing Prices 10 Overall FASB ASC 5-6 Revenue and Gains Use revenue link 69

FASB ASC 5-7 Accounting for Long-term Construction Contracts Search long term construction 605 Revenue Recognition 35 Construction-Type and Production-Type Contracts\ FASB ASC 5-8 Use of the Installment and Cost Recovery Methods Search installment method. 605-10-25-3

FASB ASC 5-9 Matching

Search matching – over 30 hits FASB ASC 5-10 Conservatism

Search conservatism 852 Reorganizations > 20 Quasi-Reorganizations > 30 Initial Measurement FASB ASC 5-11 Materiality

Search materiality - 18 hits Room for Debate Debate 5-1 Team 1 Arguments in favor of the physical capital maintenance concept 1.

The concept of physical capital maintenance is concerned with maintaining productive capacity. Productive capacity is provided by the company’s assets, and capital is defined as the operating assets of the entity. Assets must eventually be replaced in order to maintain the current level of productive capacity. Hence, measurement of assets at their replacement cost is consistent with this theory.

Under the physical capital maintenance concept current period revenues are matched with the current cost of the assets used to generate the revenue. The resulting periodic income is referred to as distributable or sustainable income because as a result of calculating depreciation and cost of goods sold based on their replacement cost, net income reflects the amount that can be distributed to stockholders without impairing the productive capacity of the entity. Thus, income is not recognized until provision has been made to replace these assets. 70

Most going concerns expect to operate in the future at a rate of physical activity equal to the current level.. Hence, periodic income should not be recognized until provision has been made to maintain the physical plant at the current level. 3.

The major strength of the physical capital maintenance concept is based on the notion that an increase in enterprise wealth as a result of price changes is excluded from income. According to SFAC No. 5, holding gains and losses are treated as adjustments to equity rather than income. Thus, the concept recognizes that long-run survival of the entity is dependent upon its ability to generate enough income to replace the productive capacity of its existing assets.

Another strength of the physical capital maintenance concept is that it provides insight regarding the amount of dividends that may be paid to investors without impairing the entity’s ability to replace existing assets.

The concept recognizes that fact that enterprises attempt to maintain share prices by maintaining operating flows. Presumably by maintaining a given level of operating capacity, the ability to maintain operating flows is greatly enhanced.

Team 2 Arguments in favor of the financial capital maintenance concept. 1.

Capital, under the financial capital maintenance concept is defined as the monetary values of assets contributed by owners at the time they were contributed. This is the traditional, dominant view of capital maintenance in accounting. The primary emphasis of the financial capital maintenance concept is on the exchange transaction and events that affect the operations and status of the business entity. Hence, most of the information that would be provided under this concept is derived from actual experiences and is thus historical in nature.

Under the financial capital maintenance concept, income results from matching revenues with the cost of generating revenues. Revenues are recognized by applying the realization principle. Accordingly, they are recognized when the earnings process is complete or virtually complete and when an exchange (transactions with customers) has taken place. Costs are matched directly with revenues (e.g., cost of goods sold), directly with the period in which revenues occurred (e.g., utility bills), and allocated to periods in which revenue is generated (e.g., depreciation).

The financial capital maintenance concept presumes that historical cost is the significant and relevant measurement approach. The major strength of this concept is that it is generally understood by users. According to SFAC No. 8, understandability is a desirable of useful accounting information.

Historical cost is objective and provides neutral, unbiased measures of the results of financial transactions and events. Because it is transactions based, the measurements are verifiable and the approach is relatively easy to apply in practice. Moreover, since revenues are not recognized until realized, the financial capital maintenance concept is conservative.

Because adjustments are not made to historical cost for changes in the price level, financial transactions are reported in terms of dollars invested by stockholders. Hence, the concept of financial capital maintenance enables accountants to fulfill their stewardship role to owners.

Debate 5-2 71

Team 1 Argue in favor of the economist’s view of income Economists generally agree that the objective of measuring income is to determine how much better off a company has become during the accounting period. This view of income is consistent with the notion of “real income”, or increases in economic wealth. Under this view, a company has income if it is better off at the end of the accounting period than at the beginning of the period and the increase is wealth is not due to investments by owners or distributions to owners. The amount of income during the period is equal to the maximum amount that could be distributed to owners and still leave the company as well off as it was in the beginning of the period. This notion is consistent with accounting for assets at current value. Economic income would take preservation of the physical plant into consideration, but would also adjust for changes in price levels. The difference between economic income and that derived from the physical capital maintenance concept is that economic income would include holding gains and losses, while physical capital maintenance income would not. According to SFAC No. 8, relevant information about an entity should provide predictive ability. Because current values represent the market’s assessment of the value of assets and hence take into consideration the future cash flows that they would generate, income measurement utilizing current values should provide information relevant to predict future cash flows. The economic view of income is consistent with recognition of income during production. It is not based on the sale of the asset to customers. Instead it is presumed that the enterprise is in business to realize cash from the production of goods and the provision of services, but that the production process itself is earning the eventual cash inflow. Hence, revenue recognition is based on expectations regarding future events rather than on the transactions as they occur. By the same token, costs would be recognized as they are incurred, rather than be matched against revenue that is recognized in accordance with the realization principle. Team 2 Argue in favor of the accountant’s concept of income Accountants feel that the elements of financial statements should be reported when there is evidence of an exchange. Revenue should be recognized only when it is earned. Accountants should not record revenue that is anticipated. Instead, the existence of revenue should be verified with evidence that an exchange has taken place. Income measurement should be based on matching efforts (costs) with accomplishments (revenues) that have actually occurred. The accountant’s concept of income is anchored on the historical cost model and is consistent with the concept of financial capital maintenance. See, Team 2 under Issue 1 for arguments favoring these concepts. Debate 5-3 Current value measures Team 1 The definition of an asset implies that assets are held to provide future benefits. A company’s future benefits are derived from its use of assets held by it. Future benefit to a company would logically be related to expected future profits and the resultant future cash inflows. Thus, it is 72

reasonable to assume that the measurement of assets should reflect those expectations. We argue that this goal is best met by reporting assets at current value, measured using exit prices. Current value embodies expectations regarding future earning power of net assets. Since assets are held because they provide future benefit, their measurement should be based on their current value in use – that is, by entry values. An entry value is the current estimated fair market price of the asset. It is the cost that a company would incur to replace an existing asset (its replacement cost). According to Edwards and Bell, current entry prices allow the assessment of managerial decisions to hold assets by segregating current value income (holding gains and losses) from current operating income. Under the assumption that operations will continue, this dichotomy allows the long-run profitability of the enterprise to be assessed. The recurring and relatively controllable profits can be evaluated vis-à-vis those factors that affect operations over time but are beyond the control of management. Replacement cost provides a measure of the cost to replace the current operating capacity and, hence, a means of evaluating how much the firm can distribute to stockholders and still maintain its productive capacity. We do not believe that exit values provide appropriate asset measures because they measure what a company could receive if they sell the asset, not what the asset is worth to company while they keep it. Team 2 Since the company already owns the assets, it will not have to replace them. Hence, replacement cost is not relevant. We agree that the value of the asset should be tied to its expected benefit to the company. However, we believe that companies benefit by future cash flows that will result from the asset, not on cash flows to purchase assets already owned. According to Sterling, entry value is irrelevant to what could be realized upon sale of those assets and to their current purchase since they are already owned. Moreover, replacement cost does not measure the capacity to make decisions to buy, hold, or sell in the marketplace. Chambers and Sterling contend that exit prices have decision relevance. Accordingly, during each accounting period, management decides whether to hold, sell, or replace the assets. It is argued that exit prices provide users with better information to evaluate liquidity and thus the ability of the enterprise to adapt to changing economic stimuli. Because management has the option of selling the asset, exit price provides a means of assessing downside risk. It measures the current sacrifice of holding the asset and thereby provides a guide for evaluating management’s stewardship function. A recent FASB pronouncement agrees with Chambers and Sterling. SFAS No. 157 defines fair value as exit price. According to the pronouncement, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition emphasizes that fair value is market based rather than entity specific. To summarize, we believe that exit value captures the reasons why management buys, holds, and sells assets. It thus discloses the value of those assets to the entity, and thus is decision-relevant to financial statement users. 73

WWW Case 5-9 a.

Companies typically recognize revenue at the point of sale. At the point of sale, the merchandise sold is typically delivered and title passes to the buyer. Hence, the earnings process is complete or virtually complete and is evidenced by an arm’s length exchange transaction. Also, there is relative certainty about the realization of the revenue in terms of cash inflow. Either the cash has been received or a measurable amount is receivable.

In this industry, the selling price is assured by the market, hence, the critical event is getting the metal out of the ground, rather than a sale transaction.

The reasoning for the typical practice is that until the sale’s transaction takes place, the earnings process is not virtually complete, and there is uncertainty about the reliability of any expected future cash flows.

Case 5-10 a. The definitions and descriptions of each of the three revenue recognition methods, and an indication as to whether they are in accordance with generally accepted accounting principles are: 1. The completion-of-production method allows revenue to be recognized when production is complete even though a sale has not yet been made. The circumstances that justify revenue recognition at this point are: • The product is sold in a market with a reasonably assured selling price. • The costs of selling and distributing the product are insignificant and can reasonably be estimated. • Production, rather than sale, is considered the most critical event in the earnings process. This method is in accordance with GAAP; however, it is an exception to the normal revenue recognition rules. 2.

The percentage-of-completion method is used on long-term projects and the following conditions must exist for its use: • A firm contract price with a high probability of collection. • A reasonably accurate estimate of costs. • A way to reasonably estimate the extent of progress to the completion of the project. Gross profit is recognized in proportion to the work completed. Normally, progress is measured as a percentage of the actual costs to date to the estimated total costs, or some other method that reasonably estimates actual completion. The method is in accordance with GAAP for long-term projects when estimates are dependable.

2. The installment-sales method allows revenue to be recognized when cash is collected rather than

at the point of sale. Due, in part, to improved credit procedures that increase the likelihood of collection, the installment-sales method of recognizing revenue is generally considered unacceptable. However, there are exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transaction or other conditions, there is no reasonable basis for estimating the degree of collectibility. When such circumstances exist, and as long as they exist, either the installment-sales method or cost-recovery method of accounting may be used. 74

The revenue to be recognized in the fiscal year ended November 30, 2014, for each of the three companies is calculated: 1. Extracta Mining would recognize as revenue the market value of metals mined during the year. Silver $ 750,000 Gold 1,400,000 Platinum 490,000 Total revenues $2,640,000 2. Softcover Paperbacks would recognize revenue of $5,600,000, calculated as follows. Sales in fiscal 2014 $7,000,000 Less: Estimated sales returns and allowances (20%) 1,400,000 Net sales—revenue to be recognized in fiscal 2014 $5,600,000 Although book distributors can return up to 30 percent of sales, prior experience indicates that 20 percent of sales is the expected average amount of returns. The collection of 2011 sales has no effect on fiscal 2014 sales recognition. The 21 percent of returns on the initial $4,800,000 of 2014 sales confirms that 20 percent of sales will provide a reasonable estimate. 3. Burgler Protection Devices would recognize revenue of $5,000,000. Revenue to be recognized represents the amount of goods actually billed and shipped when the method of recognizing revenue is at the point of sale (terms are F.O.B. shipping point).

Case 5-11 a.

FHRC should recognize revenue on the following bases: • The membership fees, which are paid in advance and sold with a money-back guarantee, should be recognized as revenue over the life of the membership. Each month, FHRC earns one-twelfth of the revenue. This results in a liability for the unearned and potentially refundable portion of the fee. For those membership fees that are financed, interest is recognized as time passes at the rate of 9 percent per annum. • Court rental fees should be recorded as revenue as the members use the courts. • Revenue from the sale of coupon books should be recorded when the coupons are redeemed; i.e., when members attend aerobics classes. At year-end, an adjustment should be made to recognize the revenue from unused coupons that have expired.

Since FHRC has not provided any service when the down payment for equipment is received, the down payment should be treated as a current liability until delivery of the equipment is made.

Since FHRC expects to incur costs under the guarantee and these costs can be estimated, an amount equal to 4 percent of the total revenue should be accrued in the accounting period in which the sale is recorded.

Case 5-12 Repo 105 is an accounting maneuver where a short-term loan is classified as a sale. In a Repo 105 transaction, the company sells assets (generally securities) and the cash obtained through this sale is then used to pay down debt. This allows the company to appear to reduce its leverage by temporarily paying down liabilities—just long enough to be reflected on the company’s published balance sheet. Subsequently, after the company’s annual report is released, the company borrows cash and repurchases its original assets. 75

Case 5-13 The answer to this case requires the student to visit the WWW to answer the questions about a company’s current financial statements. Case 5-14 a.

The economist views business income in terms of wealth of the entity as a whole resulting from an accretion attributable to the whole process of business activity. The accountant must measure the “wealth” of the entity in terms of its component parts, that is, individual assets and liabilities. The events must be identified which cause changes in financial condition of the entity and the resulting changes should be assigned to specific accounting periods. To achieve this identification of such events, accountants employ the revenue recognition principle in the measurement of periodic income.

Revenue recognition results from the accomplishment of economic activity involving the transfer of goods and services giving rise to a claim. To warrant recognition there must be a change in assets that is capable of being objectively measured and that involves an exchange transaction. This refers to the presence of an arm’s-length transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice, or may be stipulated in a contract. Note that an item should meet four fundamental recognition criteria to be recognized. Those criteria are: Definitions—The item meets the definition of an element of financial statements. Measurability—It has a relevant attribute measurable with sufficient reliability. Relevance—The information is capable of making a difference in user decisions. Reliability—The information is representationally faithful, verifiable, and neutral.

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

In the context of revenue recognition, recognition involves consideration of two factors, (a) being realized or realizable and (b) being earned, with sometimes one and sometimes the other being the more important consideration. Events that can give rise to recognition of revenue are: the completion of a sale; the performance of a service; the production of a standard interchangeable good with a guaranteed market, a determinable market value and only minor costs of marketing, such as precious metals and certain agricultural commodities; and the progress of a construction project, as in shipbuilding. The passing of time may be the “event” that establishes the recognition of revenue, as in the case of interest revenue or rental income. As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue recognized. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to estimate reasonably the related expenses. In such instances revenue recognition must be deferred until proper periodic income measurement can be achieved through the matching process. c.

No. The factor apparently relied upon by Olasabel Associates is that revenue is recognized as the services giving rise to it are performed. The firm has completed the construction of the building, obtained financing for the project, and secured tenants for most of the space. Management of the project is yet to be rendered and Olasabel did not accrue revenue for this service. However, 76

another factor must be considered. Since the fee for Olasabel’s services has as its source the future profits of the project, on June 30, 2014, there is no way to measure objectively the amount of the fee. Setting the amount at the commercial value of the services might be a reasonable approach were it not for the contingent nature of the source of the fees. That an asset, contracts receivable, exists as a result of this activity is outweighed by the inability to measure it objectively. Revenue recognition at this time is unwarranted because of the contingent nature of the revenue and the likelihood of overstating the assets. Thus, revenue recognition at this point would not be in accordance with generally accepted accounting principles. Because revenue cannot be recognized, the related expenses should be deferred so that they can be amortized over the respective periods of revenue recognition. With a reasonable expectation of future benefit, the deferred costs conform to the accounting concept of assets. Case 5-15 a.

Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This presumed direct association has been identified both as “associating cause and effect” and as “matching (expense recognition principle).” Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognizing them as expenses accompanies recognition of the revenue. Generally, the expense recognition principle requires that the revenue recognized and the expenses incurred to produce the revenue be given concurrent periodic recognition in the accounting records. Only if effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the expense recognition principle is a recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided.

Some costs are assigned as expenses to the current accounting period because 1. Their incurrence during the period provides no discernible future benefits; 2. They are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; 3. They must be incurred each accounting year, and no build-up of expected future benefits occurs; 4. By their nature they relate to current revenues even though they cannot be directly associated with any specific revenues; 5. The amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits, or both; 6. Uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose. Thus, many costs are called “period costs” and are treated as expenses in the period incurred because they have neither a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers’ salaries, advertising, research and development, and auditors’ fees. 77

A cost should be capitalized, that is, treated as a measure of an asset when it is expected that the asset will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset, a future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period’s revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise on hand at the end of an accounting period, costs of insurance coverage relating to future periods, and the cost of self-constructed plant or equipment.

In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Thus, when it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance.

A cost should be treated as a loss when no revenue results. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses result from events that are not anticipated as necessary in the process of producing revenue. There is no simple way of identifying a loss because ascertaining whether a cost should be a loss is often a matter of judgment. The accounting distinction between an asset, expense, loss, and prior period adjustment is not clear-cut. For example, an expense is usually voluntary, planned, and expected as necessary in the generation of revenue. But a loss is a measure of the service potential expired that is considered abnormal, unnecessary, unanticipated, and possibly nonrecurring and is usually not taken into direct consideration in planning the size of the revenue stream.

Case 5-16 a.

Accounting for the penalty as a charge to the current period is justified if the penalty is considered the result of an unusual event (the assessment) occurring within the period. The penalty may be an extraordinary item rather than a part of income before extraordinary items, if it is material and is unusual in nature and infrequent in occurrence. Installation of the air pollution control equipment should prevent the assessment of further penalties.

Accounting for the penalty as a correction of prior periods is justified if the penalty is considered a result of the business activities of prior periods, rather than a result of an event of the current and future periods. The penalty is assessed to correct damage which occurred as a result of production of prior periods and thus represents a cost of production which was omitted from the reported results of those prior periods. Further justification is provided by the fact that determination of the amount of the penalty was presumably made by someone other than management (the Pollution Control Agency) and could not be reasonably estimated before determination. 78

A prior period adjustment should be reported as an adjustment of the current year’s beginning balance of retained earnings, as previously reported. If statements of prior periods are presented, they should be restated to include in income before extraordinary items the portion of the penalty allocable to each period, with appropriate adjustments to other items affected, such as retained earnings, liabilities, and earnings per share. Accounting for the penalty as a capitalizable item to be amortized over future periods is justified if the penalty is viewed as a payment made to benefit future periods. If the penalty is not paid, Global Warming Company will not be allowed to operate in future periods; thus, the penalty is similar to a license to do business. Since the amortized expense will recur from period to period, it should be included in income before extraordinary items. Amortization should be computed in a rational and systematic manner.

Financial Analysis Case a.

The students answers will vary depending on the company selected. They should use the following eight techniques outlined in the text. To assess their company’s quality of earnings. 1.

2. 3. 4. 5. 6. 7. 8.

Compare the accounting principles employed by the company with those generally used in the industry and by competitors. Do the principles used by the company inflate earnings? Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings. Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods. Attempt to assess whether some expenses, such as warranty expense, are reflected on the income statement. Determine the replacement cost of inventories and other assets. Assess whether the company is generating sufficient cash flow to replace its assets. Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows. Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales. Review the MD&A section of the annual report and the auditor’s opinion to determine management’s opinion of the company’s future and to identify any major accounting issues.

Answers will vary

CHAPTER 6

Case 6-1 a.

The basic markets available to Warmen Brothers are (1) domestic screening, (2) foreign screening, (3) video rentals, (4) cable broadcasting (5) network television stations and (6) independent television stations.

The entry order should be as specified in Part a because any other order would jeopardize the maximization of revenue from each source. For example, if a film were sold to independent television stations prior to distribution to cable and network stations, the viewership levels of cable and network stations would decrease.

Revenues should be recognized from each market as they are earned under the realization principle. Under this concept, revenue from each of the markets should be recognized as contracts are signed or film rights are sold to each of the various markets.

The matching of costs with revenues for the motion picture industry is a difficult process. The amount of revenue available from secondary markets is highly dependent upon the success of the film in the domestic screening market. Consequently, holding production costs to match against secondary markets may result in distorted net income figures. Additionally, many top film stars contracts are based upon a percentage of total profits. A conservative method of recognizing costs is to charge all production costs against domestic and foreign screenings, and to charge other secondary markets only incremental costs. This is somewhat similar to the sunk cost method of income recognition. Although this method is generally not appropriate for most situations, the highly speculative nature of the secondary film markets make it an acceptable practice. During the past several years some film making companies have experienced bankruptcy partially due to faulty revenue recognition methods. Attempting to allocate production costs across all of the secondary markets will require estimates of the total revenues to be received from each of those markets prior to the distribution of the film. This is a very risky process and could lead to distorted financial statements

Recognizing all production costs in the period of domestic and foreign screenings will result in conservative income figures until the secondary market revenues are realized. This procedure might also be criticized as distorting future net income amounts because all production costs have been recognized prior to the recognition of some revenues. Never-the-less, holding production cost and matching them with secondary market revenues is a less favorable option. Note to the instructor: This solution may, or may not, be chosen by the students. It is a good example of a situation needing critical thinking skills where no clear-cut solution is available. The development of the issues is of more importance than the final decision.

Case 6-2 a..

Extraordinary items are material items of a character significantly different from the typical or customary business activities of the entity. Extraordinary items are events and transactions that are distinguished by their unusual nature and infrequent occurrence. The product tampering and recall is material because the credits and refunds alone are ten percent of earnings before income taxes, is unusual because of its catastrophic nature, and is infrequent because it is the first occurrence in the more than fifty year history of Goods Company with no indication that the event will recur.

ii.

The extraordinary charge should be properly described as "Loss from product tampering and recall" and placed in a separate section in the 2014 income statement after discontinued operations. The charge must be presented net of its applicable income taxes and the taxes may be shown parenthetically of in columnar form. Reporting per share amounts on extraordinary items is optional. Details of the extraordinary charge should be disclosed in the notes to 2014 financial statements.

Items 1, 3,5,6,7,8,10 and 13 should be included in the extraordinary charge for 2014.

ii.

Items not included in the extraordinary charge and the reason for each is as follows.

Item Number

Reason Not Included

Insurance to cover possible future events is not directly related to the 2014 event. Should be capitalized and expensed over future periods.

Future security measures are future costs and not directly related to the 2014 event. Should be expensed over future periods.

These packaging costs are not directly related to the 2014 event and should be matched against revenues from the sale of the packaged products.

These costs resulted from a decision of the company in its reaction to the 2014 event. The costs are related to future operations and should be charged to operating expense or spread over the estimated period that the redesigned package will be in use.

The cost of the packaging equipment should be charged to an asset account and expensed over its estimated useful life.

Lost sales revenue is an opportunity cost and is not recorded or disclosed anywhere on the financial statements.

Case 6-3 a.

The important distinction between revenues and gains and expenses and losses is whether or not they are associated with ongoing operations. Over the years, this distinction has generated questions concerning the nature of income reporting desired by various financial-statement users. Historically, two viewpoints have dominated this dialogue and have been termed the current operating performance concept and the all-inclusive concept of income reporting. 81

The proponents of the current operating performance concept base their arguments on the belief that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should reflect the day-to-day, profit-directed activities of the enterprise, and the inclusion of other items of profit or loss distort the meaning of the term net income. On the other hand, the advocates of the all-inclusive view believe that net income should reflect all items that affected the net increase or decrease in stockholders equity during the period, with the exception of capital transactions. Specifically, these individuals believe that the total net income for the life of an enterprise should be determinable by summing the periods’ net income figures. The underlying assumption behind this controversy is that the method of presentation of financial information is important. That is both view points agree on the information to be presented but disagree on where to disclose different types of revenues, expenses, gains, and losses. B

.i. Cost of goods sold is considered an expense under both the current operating performance and all-inclusive concepts of income. ii. Selling expenses are considered expenses under both the current operating performance and all-inclusive concepts. iii. Extraordinary items are considered gains and losses under the current operating performance concept and revenues and expenses under the all-inclusive concept. iv. Prior period adjustments are considered gains and losses under a strict interpretation of the current operating performance concept. However, they have been defined as nonowner changes in equity under Statement of Financial Accounting Concepts No.5. Prior period adjustments are considered revenues and expenses under a strict interpretation of the all inclusive concept.

Case 6-4 a.

A change from the sum-of-the-years-digits depreciation method to the straight-line method for fixed assets is a change in accounting principle. The concept of consistency presumes that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type. A change is permissible only if the enterprise justifies the preferability of an alternative acceptable accounting principle. Under the provisions of FASB ASC 250, this accounting change requires retrospective application to prior periods as if it had always been used.

If a public company obtained additional information about the service lives of some of its fixed assets showing that the service lives previously used should be shortened, such a change would be a change in accounting estimate. The change in accounting estimate should be accounted for in the year of change and future years since the change affects both. Specifically, the operating item, depreciation expense, would be increased. In addition, the effect on income before extraordinary items, net income, and related per-share amounts of the current period should be disclosed. 82

Changing specific subsidiaries comprising the group of companies for which consolidated financial statements are presented is an example of a change in the reporting entity. Such a change requires that the consolidated income statements be restated to reflect the different reporting entity.

Case 6-5 a.

Earnings per share, as it applies to a corporation with a capitalization structure composed of only one class of common stock, is the amount of earnings applicable to each share of common stock outstanding during the period for which the earnings are reported. The computation of earnings per share should be based on a weighted average of the number of shares outstanding during the period with retroactive recognition given to stock splits or reverse splits and to stock dividends, except relatively small nonrecurring stock dividends may be ignored. The computation should be made for income before extraordinary items, extraordinary items net of income tax, and net income. The earnings per share from each of the foregoing should be presented in the income statement and it is desirable that the method of computation be disclosed.

Meanings of terms often used in discussing earnings per share and the types of items to which they apply follow:

Senior securities are securities which have preference to before earnings are allocated to common stock. Cumulative preferred dividends whether or not earned should be deducted from net income except "if earned" dividends should be deducted only to the extent earned. Preferred stock is a senior security if it has a preference on dividends. Bonds are a senior security and interest expense on the bonds enters into the determination of net income.

For purposes of computing earnings per share residual securities are those securities deriving a major portion of their value from their right to be converted into common stock through the exercise of an option or conversion privilege by the owner of the security. Convertible preferred stock, convertible debt, common stock options and common stock warrants are examples of such securities.

Treatments to be given to the listed items in computing earnings per share are: i.

Dividends on preferred stock should be deducted from net income and also net income before extraordinary items before computing earnings per share applicable to the common stock and other residual securities. If the preferred stock is cumulative this adjustment is appropriate whether or not the amounts of the dividends are declared or earned.

ii.

Minor reacquisitions of outstanding common stock which are placed in the treasury may be excluded in the computation of earnings per share. However, in determining earnings per share during the period when a major acquisition of treasury common stock was made, the computation should be based on the weighted average number of shares outstanding during the period.

iii.

When the number of common shares outstanding increases as a result of a stock split during the year, the computation should be based on shares outstanding at year end and retroactive recognition should be given for an appropriate number of prior years. 83

iv.

The existence of a provision for a contingent liability on a possible lawsuit created out of retained earnings will not affect the computation of earnings per share since the appropriation of retained earnings does not affect net income or the number of shares of stock outstanding.

Outstanding preferred stock with a par value liquidation right issued at a premium, although affecting the determination of book value, will not affect the computation of earnings per share for common stock except with respect to the dividends as discussed in c.i. above.

vi.

The exercise of a common stock option which results only in a minor increase in the number of shares outstanding during the period may be disregarded in the computation of earnings per share. If, however, the exercise of a common stock option results in a major increase in the number of shares outstanding, the computation of earnings per share should be based on the weighted average number of shares outstanding during the period. The exercise of a stock option by the grantee does not affect earnings, but any compensation to the officers from the granting of the options would reduce net income and earnings per share.

vii.

The replacement of a machine immediately prior to the close of the current fiscal year will not affect the computation of earnings per share for the year in which the machine is replaced. The number of shares remains unchanged and since the old machine was sold for its book value, earnings are unaffected

Case 6-6 a

.i. The term accounting change means a change in (1) an accounting principle, (2) an accounting estimate or (3) the reporting entity. A change in accounting principle results from adoption of a generally accepted accounting principle different from the one used previously fry reporting purposes. The term accounting principle includes not only accounting principles and practices but also the methods of applying them. A characteristic of a change in accounting principle is that it concerns a choice from among two or more generally accepted accounting principles. But neither (1)initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or that previously were immaterial in their effect nor (2) adoption or modification of an accounting principle necessitated by transactions or events that are clearly different in substance from those previously occurring is a change in accounting principle. Changes in accounting principle are numerous and varied. They include, for example, a change in the method of inventory pricing, such as from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method; a change in depreciation method for previously recorded assets, such as from the double-declining balance method to the straight-line method (other than a change to the straight-line method at a specific point in the service life of an asset that was planned at the time the accelerated method was adopted to fully depreciate the cost of the asset over its estimated life); and a change in the method of 84

accounting for long-term construction-type contracts, such as from the completed contract method to the percentage-of-completion method. Changes in accounting estimates are necessary consequences of periodic presentations of financial statements. Preparing financial statements requires estimating the effects of future events. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, warranty costs, periods benefited by a deferred cost and recoverable mineral reserves. Future events and their effects cannot be perceived with certainty; estimating requires the exercise of judgment. Thus accounting estimates change as new events occur, as more experience is acquired or as additional information is obtained. Distinguishing between a change in accounting principle and a change in an accounting estimate sometimes is difficult. For example, a company may change from deferring and amortizing cost to recording it as an expense when incurred because future benefits from the cost have become doubtful. The new accounting method is adopted, therefore, in partial or complete recognition of the change in estimated future benefits. The effect of the change in accounting principle is inseparable from the effect of the change in accounting estimate. Changes of this type often are related to the continuing process of obtaining additional information and revising estimates and are therefore considered as changes in estimates. Changes in the reporting entity are limited mainly to (1) presenting consolidated or combined statements in place of statements of individual companies, (2) changing specific subsidiaries comprising the group of companies for which consolidated financial statements are presented and (3) changing the companies included in combined financial statements. A different group of companies comprises the reporting entity after each change. ii. A correction of an error in previously issued financial statements concerns factors similar to those relating to an accounting change. Errors in financial statements result from mathematical mistakes, mistakes in the application of accounting principles or oversight or misuse of facts that existed at the time the financial statements were prepared. In contrast a change in accounting estimate results from new information or subsequent developments and accordingly from better insight or improved judgment. Thus an error is distinguishable from a change in estimate. A change from an accounting principle that is not generally accepted to one that is generally accepted to one that is generally accepted is considered to be a correction of an error. b.

There is a presumption that an accounting principle once adopted should not be changed in accounting for events and transactions of a similar type. Consistent use of accounting principles from one accounting period to another enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data. The presumption that an entity should not change an accounting principle may be overcome only if the enterprise justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. But a method of accounting that was previously adopted for a type of transaction or event that is being terminated or that was a single, nonrecurring event in the past should not be changed. For example, the method of accounting should not be changed for a tax or tax credit that is being discontinued or for preoperating costs relating to a specific plant. But this does not imply that a change in the estimated period to be benefited for a deferred cost (if 85

justified by the facts) should not be recognized as a change in accounting estimate. The issuance of an Accounting Standards Update by the FASB that creates a new accounting principle, that expresses a preference for an accounting principle is sufficient support for a change in accounting principle. The burden of justifying other change rests with the entity proposing the change. The nature of and justification for a change in the method of inventory pricing should be disclosed in the financial statements for the period the change was adopted; the change should be justified on the basis that the new method is more appropriate than the old. In addition, the effect of the change on income before extraordinary items, net income and the related per share amounts should be disclosed for all periods presented. This disclosure may be on the face of the income statement or in the notes. Financial statements of subsequent periods need not repeat the disclosures. In one specific situation the application of these provisions may result in financial statement presentations of results of operations that are not of maximum usefulness to intended users. For example, a company owned by a few individuals may decide to change from one acceptable inventory method to another in connection with a forthcoming public offering of shares of its equity securities. The potential investors may be better served by the statements of income for a period of years reflecting the use of the newly adopted accounting principle because it will be the same as that expected to be used in future periods. In recognition of this situation, financial statements for all prior periods presented may be restated retroactively when a company first issues its financial statements for any one of the following purposes: (1) obtaining additional capital from investors, (2) effecting a business combination or (3) registering securities. This exemption is available only once for changes made at the time a company's financial statements are first used for any of the purposes and is not available to companies whose securities currently are widely held. Under these specific circumstances the company should disclose in financial statements issued the nature of the change in accounting principle and the justification for it. C & d. The general conclusion of APB Opinion No. 20 was that previously issued financial statements need not be revised for changes in accounting principles. However, the FASB revisited this issue and in May 2005 issued SFAS No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3,” now contained at FASB ASC 250-10. This pronouncement required retrospective application to prior periods’ financial statements of changes in accounting principles. Retrospective application is defined at FASB ASC 250-10-20 as: The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years. When it is impracticable to determine the period-specific effects of an accounting change on one or more prior periods presented, or the cumulative effect FASBASC 250-10, requires that the new accounting principle be applied to the balances of the appropriate assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than being reported in an income statement. Finally, FASB ASC 250-10 requires that a 86

change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate (discussed below) effected by a change in accounting principle. Case 6-7 Situation 1 a. A change in the depreciable lives of fixed assets is a change in accounting estimate. b. In accordance with generally accepted accounting principles, the change in estimate should be reflected in the current period and in future periods. c. This change in accounting estimate will affect the statement of financial position in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the earnings statement in the current and future years. d. A footnote should disclose the effect of the change in accounting estimate on income before extraordinary items, net income, and related per-share amounts for the current period. Situation 2 a. The change from reporting the investment in Allen using the cost method to using a consolidated financial statement basis is a change in reporting entity. The change in reporting entity is actually a change in accounting principle, but the APB Opinion No. 20 excluded this change from the general category to give it special reporting procedures. b. A change in reporting entity is effected and disclosed by restating all prior-period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by footnote, but subsequent financial statements need not repeat the disclosures. c. The statement of financial position will be affected by this change in that the investment account of the parent and the equity section of the subsidiary will be eliminated, intercompany accounts will be eliminated, and a goodwill account as well as a minority interest account may arise. The income statement will be affected in that intercompany transactions will be eliminated and a minority interest in earnings will be shown. Also, if goodwill has been created, the income statement may disclose an expense for goodwill impairment. d. The financial statements of the period of the change in the reporting entity should describe by footnote disclosure the nature of the change and the reason for it. In addition, the effect of the change in earnings before extraordinary items, net earnings, and related per-share amounts should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures. Situation 3 87

a. The change in the method of computing depreciation for all fixed assets (previously recorded and future acquisitions) represents a change in an accounting estimate. b. Accordingly, the effect of the change should be reflected in the current-year future financial statements. c. As a result of the change to straight line, current and future depreciation charges will differ from what they might have been under the accelerated method, the direction of this difference will depend on the life of the individual assets. d. The nature of and justification for the change should also be disclosed in the footnotes to the financial statements. Case 6-8 a.

Morgan should recognize the change in depreciation method as a change in accounting estimate

The effects of the hailstorm should be reported as an extraordinary item in the income statement because it meets both of the criteria for classification as an extraordinary item. It is unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates.

The classification in the income statement of an extraordinary item differs from that of an operating item in the following ways. First, an extraordinary item should be shown as a separate item in the income statement below the continuing operations section of the income statement. Second, an extraordinary item should be shown net of applicable income taxes. An extraordinary item is unrelated to Morgan's normal and ongoing operations.

Case 6-9 a.

Under the current operating performance concept of income, only changes and events under the control of management that result from current period decisions should be included in income. Normal and recurring items should constitute the basis for evaluating current period performance.

Earnings as defined under SFAC No. 5 reflect the current operating performance concept because it excludes cumulative effects of changes in accounting principles. These effects are the accumulation of differences in earnings of prior periods that would have occurred had the new method been used in the past rather than the old one. Because cumulative effects relate to the past, they are not relevant in assessing current operating performance and as such should be excluded from the current period measurement of income.

Under the all-inclusive concept of income, net income would reflect all items that affected the net increase or decrease in equity (net assets) during the accounting period, with the exception of capital transactions (investments by owners and distributions to owners).

The definition of comprehensive income is that it is the change in net assets occurring during the accounting period from non-owner sources. Since it would therefore include the effects of all items that affected the net increase or decrease in equity during the accounting period exclusive of transactions with owners, this definition essentially reflects the all-inclusive concept of income.

Under the financial capital maintenance concept of income, income is the change in the recorded (monetary) values of net assets occurring during the accounting period which do not result from investments by owners or distributions to owners. These changes would include recorded changes due to changes in price level (holding gains and losses) as well as changes due to the cumulative effect of accounting changes. Hence, comprehensive income, which purports to measure these changes in net assets relies upon the financial capital maintenance concept and hence is consistent with it.

For financial reporting practices to be consistent with the concept of physical capital maintenance, assets would need to measured at current replacement values and holding gains and losses would be removed from the income statement and treated as equity adjustments. Current practice for recording net assets is slowly evolving in this direction. For example, investments in equity securities with readily determinable fair values and investments in debt instruments are reported at fair value, a current value measure. Moreover, the gains and losses resulting from revaluing investments in securities that are classified as available for sale are excluded from net income and treated as adjustments to equity. Accounting for impaired loans and impaired fixed assets also results in the recording of fair value when impairment occurs.

FASB ASC 6-1 Extraordinary Items Search extraordinary items Extraordinary items are contained at FASB ASC 225-20. FASB ASC 225-20-55-3&4 give examples of items that satisfy and fail to satisfy the infrequent and unusual criteria. The only EITF pronouncement dealing with extraordinary items identified in the FASB ASC is: 225-20-20 Glossary Business Interruption Insurance FASB ASC 6-2 Comprehensive Income Reporting Comprehensive Income is contained in sections FASB ASC 220-10-45. It is found by searching comprehensive income or by cross referencing SFAS No. 130.

FASB ASC 6-3 Net Income Found by searching net income 205-10 and 220-10 FASB ASC 6-4 APB Opinion No. 9 Found by cross reference to APB No. 9. 225-10-05-05 FASB ASC 6-5 Extraordinary Items 89

Search extraordinary items 225-20

FASB ASC 6-6 Discontinued Operations Search discontinued operations. 205-20 FASB ASC 6-7 Accounting Changes Search accounting changes 250-10 FASB ASC 6-8 Earnings Per Share Search earnings per share 260-10 Room for Debate Debate 6-1 Team 1 Defend comprehensive income 1.

Comprehensive income is the change in net assets during the period, excluding transactions with owners. Thus it is consistent with the all-inclusive concept of income and provides income measures which are closer to economic (real) income than is provided by net income, and with the financial capital maintenance concept of income. In 1936, the AAA stated that income should reflect all revenue properly given accounting recognition and all costs written off during the accounting period regardless of whether or not they are the results of operations in that period. Such inclusion is needed to determine those amounts that are available for distribution to stockholders. It thus provides an appropriate measure of the change in wealth (income) of the enterprise and the change in wealth provided by the enterprise to its owners.

Comprehensive income would include changes due to price level, holding gains, which under GAAP are excluded from net income. These changes provide information on the effectiveness of the company’s investment strategies and the changes in wealth resulting from those strategies.

Comprehensive income includes the effects of all non-owner changes that previously were reported as separate adjustment to equity. Their inclusion in comprehensive income is preferable because these are non-owner changes, and hence affect owner’s wealth during the accounting period. As such they affect enterprise performance during the period are properly included as components of income. 90

Comprehensive income is consistent with the concept of financial capital maintenance because it includes all reported items that affect net assets during the accounting period. It does not strictly follow historical cost, but it does include holding gains and losses in the computation of income.

Team 2 Oppose comprehensive income 1.

Comprehensive income should not be reported because it is not consistent with the currentoperating performance concept of income and it represents a departure from the realization principle

For the most part, net income includes the results of transactions and events on the performance of the company for the period. It is historical in nature and provides accounting information which is relevant, objective and reliable. It provides information to investors on how their monetary investments were used to generate dollars for the enterprise and to increase investor wealth.

Because net income is primarily based on the current-operating concept of income, it provides predictive ability regarding future performance of the company. It shows the amount of revenues realized or realizable during the accounting period. These amounts can be extrapolated into the future. It shows the expenses associated with generating those revenues. These too can be extrapolated.

Comprehensive income includes items which do not have predictive ability. It includes the effects of price level adjustments and foreign currency translation adjustments. Including holding gains and losses obscures the measure of income available for distribution to stockholders. Holding gains have not been realized and are not yet available for distribution. Foreign currency translation adjustments are bookkeeping “plugs” that result from using the average exchange rate for income statement adjustments and the current rate for balance sheet adjustments. They are not realized and do not affect the amount of dollars that are currently.

Debate 6-2 Income Concepts Comprehensive Income Issues about income reporting have been characterized broadly in terms of a contrast between the current operating performance and the all-inclusive income concepts. Although the FASB generally has followed the all-inclusive income concept, as introduced in Chapter 5, it has made some specific exceptions to that concept. Several accounting standards require that certain items that qualify as components of comprehensive income bypass the income statement. Other components are required to be disclosed in the notes. The rationale for this treatment is that the earnings process is incomplete. Examples of items currently not disclosed on the traditional income statement and reported elsewhere are unrealized gains and losses on available for sale securities and certain foreign currency gains and losses. Current operating performance concept (COPC): The application of this concept is one of the two main approaches to measuring earnings. The concept is explained in the International Accounting Standard No.8, “Unusual and Prior Period Items and Changes in Accounting Policy”. When earnings are measured on the basis of this concept, such earnings consist of income from normal enterprise operations before non-recurring items (such as write-offs) and capital gains and losses are accounted for. 91

This latter concept would require the income statement to be designed on what might be called a ‘current operating performance’ basis, because its chief purpose is to aid those primarily interested in what a company was able to earn under the operating conditions of the period covered by the statement.” Team 1 As advocates of the all-inclusive concept of income (sometimes called clean surplus), we hold that net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period, with the exception of capital transactions. We believe that the total net income for the life of an enterprise should be determinable by summing the periodic net income figures. We advocate the all-inclusive income statement because we feel that it is more transparent to have everything clearly disclosed in the income statement, and that to put items directly into retained earnings does not meet the criterion of full disclosure. Further, we believe that the allinclusive concept of income aids in the avoidance of biased reporting, where management might be able to pick and chose what to report in the income statement. The FASB noted in SFAC No. 5 that the all-inclusive income statement is intended to avoid discretionary omissions from the income statement, even though “inclusion of unusual or nonrecurring gains or losses might reduce the usefulness of an income statement for one year for predictive purposes.” The FASB has also stated that because the effects of an entity’s activities vary in terms of stability, risks, and predictability, there is a need for information about the various components of income. Consistent with the above, the FASB now requires that companies report Comprehensive income – the change in net assets that do not result from transactions with owners. Comprehensive income includes earnings (net income) plus all other changes in net assets from non-owner events or transactions. For example, translation adjustments and changes in the value of investments in available-for-sale securities are not included in net income, but are included in comprehensive income. Team 2 Members of our team are proponents of the current operating performance concept of income. We base our arguments on the belief that only changes and events controllable by management that result from current-period decisions should be included in income. This concept implies that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should reflect the day-to-day, profit-directed activities of the enterprise, and the inclusion of other items of profit or loss distorts the meaning of the term net income. We believe that income statements that report only the current operating performance of the company provide an appropriate basis for comparing one firm with another and for comparing what a company does from one year to the next. A purpose of financial reports is to provide users with a means of predicting future cash flows. If so, a current operating performance measure of income is more relevant for decision-making. It would not include non-recurring items. So, it could be more readily relied upon as a basis for prediction. This helps fulfill the concept of relevance because it would provide predictive and feedback value. 92

WWW Case 6-10 The company’s primary financial statements provide information about the earnings of a company and its present cash flows. The primary financial statements also provide information about financial position, including assets and debt, and can use this information to evaluate risk, such as liquidity risk. Investors can use this information to project the amount and timing of future cash flows. These projections are then used to value the company. Hence, the primary financial statements meet the objectives of financial reporting found in SFAS No. 8. According to SFAS No. 8 financial statements provide information useful for investors, creditors and other users. They provide information useful in projecting the amount and timing of future cash flows. They provide information about resources and claims to resources (provided by balance sheet.) They provide information about how those resources are used and about company performance. Case 6-11 1. No disclosure is required. The error has “washed out”; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated. 2. Extraordinary item. The sale of the auto is material, unusual in nature, and infrequent in occurrence. 3. Should be reported as depreciation expense in body of income statement, based on the new useful life. Changes in the estimated useful life of assets are changes in estimates that are reported in the current and future periods. 4. No separate disclosure is generally required. This is a change in estimate that is considered part of normal business activity. 5. Report in the body of the income statement, possibly as an unusual item. The sale of the subsidiary does not meet criteria for either the disposal of a component of the business or an extraordinary item. 6. Adjustment to the beginning balance of retained earnings. A change in inventory methods is a change in accounting principle and prior periods are adjusted. 7. Report in body of the income statement, possibly as an unusual item. The loss on the preparation of such proposals is not considered extraordinary in nature. 8. Report in body of the income statement, possibly as an unusual item. Strikes are not considered extraordinary items. 9. Prior period adjustment, adjust beginning retained earnings. Corrections of errors are shown as prior period adjustments. 10. Extraordinary item. This occurrence is material, unusual in nature, and infrequent in occurrence. 11. Discontinued operations. The division’s assets, results of operations, and activities are distinguishable physically, operationally, and for financial reporting purposes. Case 6-12 The new proposed income statement has separate categories for the disclosure of a company’s operating business, its financing activities, investing activities, and tax payments. Each category also contains an income subtotal. The proposal adopts a single statement of comprehensive 93

income format that combines income statement elements and components of other comprehensive income into a single statement. Items of other comprehensive income are to be presented in a separate section following the income statement elements. This presentation format includes a subtotal of net income and a total of comprehensive income in the period. The Boards the eliminated the current alternative presentation format that allows items of other comprehensive income to be presented either: (1) On a separate statement, (2) On a combined statement of comprehensive income, or (3) On the statement of stockholder’s equity because research studies suggested that investors and other users’ ability to process the information will be enhanced if a uniform format of comprehensive income statement is presented. According to the proposal, all income and expense items will be classified into operating, investing, and financing categories. Within those categories, an entity will disaggregate line items by function. Within those functions, an entity should further disaggregate line items by nature when such presentation will enhance the usefulness of the information in predicting future cash flows. Function refers to the primary activities in which an entity is engaged. For example, an entity’s operating activities consist of selling goods, marketing or administration. Nature refers to the economic characteristics or attributes that distinguish assets, liabilities, and income and expense items that do not respond equally to similar economic events. Examples of disaggregation by nature include disaggregating total sales into wholesale and retail or disaggregating total cost of sales into materials, labor, transport, and energy costs. The desegregations will result in more subtotals than current income statement therefore facilitate the comparison of effects across financial statement. Another difference between the proposed format and current practice is in the treatment of foreign currency transaction gains and losses. Currently, these gains and losses are reported in the income statement at a net amount. Under the proposal, individual foreign currency transactions gains or losses are to be included in the same category as the related asset or liability on the balance sheet. Gains or losses may also arise when a company remeasures its subsidiary’s financial statements from the local currency to its functional currency. The proposal requires companies to identify the components of gains or losses from remeasurement and classify them into the operating, investing or financing categories accordingly. The Boards agreed on retaining the current intraperiod tax allocation method. The Boards did not support allocation of income tax expense or benefit to the operating, investing, financing asset, or financing liability categories because they determined that the cost of doing so would exceed the benefit. Similarly, there are no proposed changes in the current reporting format for discontinued operations, extraordinary items and changes in accounting principles. The exposure draft didn’t provide guidance on which items should be included in the comprehensive income because they are discussed in other exposure drafts. Case 6-13 IAS No. 8 indicates that in making that judgment, the following sources should be considered in descending order: • the requirements and guidance in IASB standards and interpretations dealing with similar and related issues; and •

the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework for the Presentation of Financial Statements.

•

the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.

•

other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph.

Case 6-14 a.

The objective of IAS 1 is to prescribe the basis for presentation of general-purpose financial statements, to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities. IAS No. 1 indicates that a complete set of financial statements should include a statement of comprehensive income for the period (or an income statement and a statement of comprehensive income). An entity has the choice of presenting a single statement of comprehensive income or two statements: an income statement displaying components of profit or loss and a statement of comprehensive income that begins with profit or loss and displays components of other comprehensive income. It requires that as a minimum, the statement of comprehensive income include line items that present the following amounts for the period: revenue, finance costs, share of the profit or loss of associates and joint ventures accounted for using the equity method, tax expense, a single amount comprising the total of the post-tax profit or loss of discontinued operations, and the post-tax gain or loss recognized on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation, profit or loss, each component of other comprehensive income classified by nature, share of the other comprehensive income of associates and joint ventures accounted for using the equity method, and total comprehensive income.

Case 6-15 The solution to this case depends upon the companies selected. Requiring the students to print the relevant information from the financial statements is a good method to use to check their answers. Financial Analysis Case Solution will depend on the companies selected to analyze.

CHAPTER 7 Case 7-1 a.&b.

The weaknesses in the Statement of Financial Position for Linus Construction Company and preferable accounting treatments are: 1. Materials, supplies, labor and overhead charged to construction. The balance of this work in progress inventory account includes actual costs incurred to date (per entry a) plus accrued profits (per entry b) while accounts receivable are carried at cost until a job is completed. Thus the Company is reflecting a balance in this inventory account which might be proper under the percentage-of-completion method. At the same time it reports a substantial balance under Deferred Liabilities in the account, Unearned Revenue on Work in Progress. Clearly, a hybrid accounting procedure is in use which should be explained by a footnote, or the statement should be modified to reflect the completed contract method. If the balance in the Unearned Revenue on Work in Progress account is retained, the portion reflecting anticipated profits should be reclassified and presented as a contra account to Materials, Supplies, Labor and Overhead Charged to Construction. The reductions in the Accounts Receivable account for collections from customers might be classified as an advance and given an appropriate title. 2. Materials and supplies not charged to construction. The basis of valuation of this inventory account (e.g., cost and how arrived at) should be disclosed. 3. Deposits made to secure performance of contracts. Since the first item of additional data suggests that the firm's operating cycle is 18 months, this account appears to be properly classified. Only to the extent that these deposits are not available for meeting obligations properly classified as current should this amount be reported under some noncurrent asset category, such as Other Assets or Investments and Funds. 4. Depreciation and value. Use of these terms in the Property, Plant and Equipment caption is not ideal. "Less accumulated depreciation" or "less depreciation recorded to date" would be more suitable. Substitution of "book value" or "carrying value" for "value" would be desirable since the word "value" standing at the head of the column alone may connote that the amounts shown are current or realizable values. 5. Land and buildings should not be presented as a single lump-sum item; the cost of each asset may be significant and only the buildings are subject to depreciation. 6. Payments made on leased equipment. The explanation given indicates that this is an unusual item; thus a note or footnote presenting the initial facts should be incorporated in the statement. The descriptive item and $230,700 amount (or perhaps 70% thereof) should be reported under Other Assets since the assets to which the payments pertain have not been purchased as of the date of the statement. The $1 nominal carrying value is improper and the $230,699 should be eliminated from the statement. Because your client should use a 96

completed-contract basis and because the normal operating cycle probably is around 18 months rather than the usual 12 months, it seems appropriate to classify the $230,700 (or 70% thereof) as an asset rather than as an expense. Under the matching concept, it is not necessary to know the amount of the expense until the amount of the revenue is known, which will be upon completion of a contract. At that time, the client makes a decision concerning the purchase of equipment. If the equipment is not purchased, the total lease rental payments are expensed. If purchased, the purchase price is recorded as an asset and the appropriate depreciation expense is recognized. 7. Prepaid taxes and other expenses were once properly reported as a deferred charge and the practice has not wholly disappeared. A preferred classification would be Current Assets. 8. Points charged on a mortgage note are in reality a discount which raises the effective interest rate on the note. Such discounts should be accounted for in the same manner as discounts on bonds payable and preferably are shown as contra items under liabilities. 9. Deferred liabilities is apparently a substitute for terminology such as Long-Term Liabilities; use of the latter is preferable. 10. Mortgage note payable. Both the interest rate and maturity date should be shown. The security for the note should also be disclosed. 11. Unearned revenue on work in progress. As noted under number 1 above, the portion representing anticipated profits should either be reported in a contra account to Materials, Supplies, Labor and Overhead Charged to Construction or be eliminated from the statement. The balance of this account may be reclassified as Partial Billings on Construction in Progress. 12. 6% preferred stock at par value is inadequately presented. No indication is given as to the number of shares authorized or issued or as to the way(s) in which the stock is preferred. Similarly, details as to dividends, such as participation, cumulation and arrearages have been omitted. 13. Common stock at par value does not indicate the number of shares authorized and issued; these details should be reported. 14. Paid-in surplus is now regarded as obsolete terminology; "capital contributed in excess of par" or "premium on capital stock" would be more suitable titles. Further, there is no indication as to whether all of the balance relates to preferred stock, to common, or both. 15. Treasury stock at cost-370 shares should identify the class or classes of shares represented. A possible question which arises in connection with such stock is whether there also should be an appropriation of retained earnings. Laws of some states make such an appropriation mandatory; discretionary appropriation is a possibility in other jurisdictions. Case 7-2 a.

The determination of current values for: Investments -

Current quotes for stocks and bonds. 97

Land Buildings Equipment Patents Copyrights Trademarks Franchises b.

Current market values or appraisal values. Current market values or appraisal values Current selling prices and/or appraisal values. Appraisal values or current selling price. Appraisal values or current selling price. Appraisal values or current selling price. Current selling price.

The use of current values might cause earnings volatility because of fluctuations in the values of assets from year-to-year. That is, the value of various asset might change thereby causing an increase or decrease in earnings that had nothing to do with the sale of the company's products or services. Such volatility could make investment and credit decisions much more difficult. Current cost data could be manipulated for example by selecting the most optimistic appraisers to value assets without a determinable market price. SFAS 157 does not require any new fair value measurements rather it is applicable under other accounting pronouncements that require or permit fair value measurements such as, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 is applicable to the valuation of securities. That is, SFAS 115 requires companies to use fair value to price investments on their balance sheets and 157 outlines the procedures they are to use to determine that fair value.

SFAS 157 does not require any new fair value measurements rather it is applicable under other accounting pronouncements that require or permit fair value measurements such as, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 is applicable to the valuation of securities. That is, SFAS 115 requires companies to use fair value to price investments on their balance sheets and 157 outlines the procedures they are to use to determine that fair value.

Case 7-3 The answers to this question are dependent upon the company selected. The students should be able to easily address each part of this question and reference the section(s) of the statement of cash flows containing the proper information. Case 7-4 A variety of measurement techniques are used to disclose the value of assets and liabilities on the balance sheet. For example, on the asset side, cash is measured at its current value, accounts receivable may be measured at expected net realizable value, marketable securities may be measured at market value or historical cost, inventories are measured at the lower of cost or market, investments may be measured at the lower of cost or market or historical cost, and plant and equipment or intangibles are measured at their unamortized cost. As with assets, liabilities are also measured by a number of different techniques. Most current liabilities are measured by the amount of resources is will take to cancel the obligation without considering the time value of money; whereas, long-term liabilities are frequently measured by the present value of future payments discounted at date of issue yield rate. Case 7-5 98

The cash inflows and outflows of a business are of primary importance to investors and creditors. The presentation of cash flow information by a business enterprise should enable investors to (1) predict the amount of cash that is likely to be distributed as dividends or interest in the future and (2) evaluate the potential risk of a given investment.

The presentation of cash flow data is necessary to evaluate a firm's liquidity, solvency and financial flexibility. Liquidity is the firm's ability to convert an asset to cash or to pay a current liability. It is referred to as the "nearness to cash" of an entity's economic resources and obligations. Liquidity information is important to users in evaluating the timing of future cash flows; it is also necessary to evaluate solvency and financial flexibility.

ii.

Solvency refers to a firm's ability to obtain cash for business operations. Specifically, it refers to a firm's ability to pay its debts as they become due. Solvency is necessary for a firm to be considered a "going concern." Insolvency may result in liquidation and losses to owners and creditors. Additionally, the threat of insolvency may cause the capital markets to react by increasing the cost of capital in the future; that is, the amount of risk is increased .

iii. Financial flexibility is the ability of a firm to use its financial resources to adapt to change. It is the ability of a firm to take advantage of new investment opportunities or to react quickly to a crisis situation. Financial flexibility comes in part to quick access to the company's liquid assets. However, liquidity is only one part of financial flexibility. Financial flexibility also stems from a firm's ability to generate cash from its operations, contributed capital or the sale of economic resources without disrupting continuing operations. Case 7-6 a.

There is no one correct answer to this question. It is intended to make the students think about the relative importance of the individual financial statements. One could argue that both the income statement and the balance sheet are important, but serve different purposes. The balance sheet is intended to report on the status of economic resources and claims to those resources. If those values are measured directly, rather than as income statement residuals, then they should be more meaningful to decision makers. Because the financial statements are articulated, income statement measures are become residuals. Perhaps financial statements should not be articulated.

The balance sheet is useful to investors because it describes the resources and claims to resources at a point in time. This information is considered useful to decision making in SFAC No. 8. The information helps users identify the enterprise’s strengths and weaknesses and assess its liquidity and solvency. It provides direct indications of the cash flow potentials of some resources and of the cash needed to satisfy many, if not most, of its obligations.

The statement “financial statements are articulated” means that measurements in the balance sheet are directly linked to those found in the income statement. According to SFAC No. 6, stocks (assets, liabilities and equity) are changed by flows (revenues, expenses, gains & losses) and at any time are their cumulative result. For example, the value of net plant assets is 99

decreased by the accumulation of depreciation expense. Moreover, an increase (decrease) in an asset cannot occur without a corresponding decrease (increase) in another asset [e.g., the collection of accounts receivable], or a corresponding increase (decrease) in a liability or equity. The result is financial statements that are fundamentally interrelated such that chances in the elements of one are associated with changes in the other. d.

Measurements that are currently reported in balance sheets that are consistent with the physical capital maintenance concept include investments accounted for under SFAS No. 115, impaired fixed assets, and impaired receivables. Also, inventory reported at market under the concept of lower-of-cost or market are consistent with this concept

Many values in the balance sheet are based on the historical cost principle and as such are not consistent with the physical capital maintenance concept of income. These values include inventory reported at cost, property plant and equipment reported at cost less accumulated depreciation, intangible assets reported at cost less accumulated amortization, investments in equity securities reported under the equity method of accounting, investments in debt securities reported at amortized cost, and most debt is reported using amortized cost based on historical interest rates.

Case 7-7 a.

Yes. However, this is the opinion of the authors, the student should be encouraged to express his/her own opinion. There is no one correct answer to this question. One possible solution follows: The investor needs to know what the operating assets (physical plant) of the entity is generating. Interest expense is, in my opinion a financing activity. It is the cost of borrowing not a cost of operations. The corporation could alternatively finance operations by issuing stock. The form of financing should not affect the measurement of inflows and outflows from operations. Similar arguments could be made for interest revenue and other nonoperating items.

Yes. Again, the student should be encouraged to express his/her own opinion. Investments in operating assets generate operating revenues and expenses. Investments in other assets such as stocks and bonds are associated with peripheral activities of the business. The results of investments of this sort are, in my opinion, investing activities. They are associated with cash management, an investing activity, not operations.

Yes. Again, the student should be encouraged to express his/her own opinion. The gain or loss on the sale of investments generates tax payments or tax savings. These tax effects affect the net cash flow from the sale. This idea is consistent with notions of capital budgeting. In the capital budgeting context, decisions to invest are a function of expected cash flows to be generated by making the investment. The sale of the asset is disinvesting. The expected cash flow, net of taxes, determines whether the investment will take place. Since the cash flows associated with investing are considered an investing activity, it follows that the cash flows associated with disinvesting (the cash inflow from the sale as well as its tax effect) are also an investing activity. Moreover, disinvesting is not an operating activity. It does not result from, nor is it associated with, the purchase or sale of goods or services. If not, the tax effect of disinvesting is not associated with operations. 100

Case 7-8 The format required by SFAS No. 95 for the presentation of the statement of cash flows evolved over a number of years. In 1980 the FASB issued a discussion memorandum entitled Reporting Funds Flows, Liquidity and Financial Flexibility as a part of the conceptual framework project. The major questions raised in this Discussion Memorandum included: 1. 2. 3. 4. 5.

Which concept of funds should be adopted? How should transactions not having a direct impact on funds be reported? Which of the various approaches should be used for presenting funds flow information? How should information about funds flow from operations be presented? Should funds flow information be separated into outflows for (a) maintenance of operating capacity, (b) expansion of operating capacity, and (c) nonoperating purposes?

Later in 1981, an exposure draft entitled Reporting Income, Cash Flows, and Financial Position of Business Enterprises was issued by the FASB. This exposure draft concluded that funds flow reporting should focus on cash rather than working capital. However, a final statement was not issued during this time and the FASB decided to consider the subject of cash flow reporting in connection with a study of recognition and measurement concepts. In 1984 the FASB issued SFAC No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises." Included in this statement is the conclusion that a cash flow statement should be part of a full set of financial statements. Concurrently, the Financial Executives Institute was reviewing the issue of cash flow reporting. In 1984 this organization published The Funds Statement: Structure and Use. This study pointed out several areas of diversity inherent in the Statement of Changes in Financial Position. For example, APB Opinion No. 19 allowed different definitions of funds, different definitions of cash and cash flow from operations, and different forms of presentation of the statement of changes in financial position. During 1985 and 1986, the FASB organized a task force on cash flow reporting, and issued an exposure draft that proposed standards for cash flow reporting. The FASB was concerned that the divergence in practice affected the understandability and usefulness of the information presented to investors, creditors, and other users of financial statements. Additionally, some financial statement users were contending that accrual accounting had resulted in net income not reflecting the underlying cash flows of business enterprises. That is, too many arbitrary allocation procedures, such as deferred taxes and depreciation, resulted in a net income figure that was not necessarily related to the earning power of an enterprise. The primary purpose of the statement of cash flows is to provide relevant information about cash receipts and cash payments of an enterprise during a period. This purpose is consistent with the objectives and concepts delineated in SFAC Nos. 8 and 5. SFAC No. 8 stresses that financial reporting should provide information to help present and potential investors assess the amount, timing, and uncertainty of prospective cash receipts from interest, dividends, the sale of securities, and the proceeds from loans. These cash flows are seen as important because they may affect an enterprise's liquidity and solvency. SFAC No. 5 indicated that a full set of financial statements should show cash flows for the period. SFAC No. 5 also described the usefulness of cash flow reporting in assessing an entity's liquidity, financial flexibility, profitability, and risk. 101

These objectives and concepts delineated in SFAC Nos. 8 and 5 (and previously in SFAC No. 1) led the FASB to conclude that the statement of cash flows should replace the statement of changes in financial position as a required financial statement. The statement of cash flows is intended to help investors, creditors, and others assess future cash flows, provide feedback about actual cash flows, evaluate the availability of cash for dividends and investments and the enterprise's ability to finance growth from internal sources, and identify the reasons for differences between net income and net cash flows. An additional reason for the focus on cash rather than working capital is the questionable usefulness of working capital in evaluating liquidity. That is, a positive working capital balance does not necessarily indicate liquidity and a negative working capital balance may not indicate a lack of liquidity. More information is needed on receivable and inventory financing to evaluate the overall liquidity of a business enterprise. FASB ASC 7-1 Classification of Savings Accounts by Credit Unions The answer is found at FASB ASC 942-405-55. Most easily found by searching for credit union share accounts and then using the topic search for 942-405 -55 FASB ASC 7-2 Link toPresentation-StatementofCshflowsTopic230 Then access printer friendly with sources FASB ASC 7-3 Search historical cost – 29 hits FASB ASC 7-4 Search current cost - over 300 hits FASB ASC 7-5 Search FAS 157 in Cross Reference Found at 820 Fair Value Measurements and Disclosures FASB ASC 7-6 The presentation of the statement of cash flows is found at FASB ASC 230. It can be accessed through the presentation link or by searching “statement of cash flows.” The students’ answers should contain the following: FASB ASC 7-7 Search development stage enterprise – Topic 915 Room for Debate Debate 7-1

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Team 1

Argue that the statement of cash flows, not the income statement, is the most important financial statement.

Investors need information to predict the amount and timing of future cash flows and to assess risk. Net income is derived from accrual based accounting procedures and cannot measure cash flow. It is logical that prior cash flows should be useful in predicting future cash flows.

The statement of cash flows discloses the effects of earnings activities on cash resources, how cash was acquired and how it was spent.

Results of empirical research indicates that cash flow data may provide information which is has incremental information content in addition to that provided by accrual based income figures. Moreover, cash flow data is superior to working capital (an accrual based measure). Taken together this evidence indicates that cash flow data provides information that it results in better decisions. Also knowledge of prior cash flows has been shown to improve predictions of future cash flows.

Team 2

Present arguments that the income statement, not the statement of cash flows, is the most important financial statement. SFAC No. 8 stresses the importance of the income statement by indicating that the primary focus of financial reporting is to provide information about a company’s performance provided by measures of earnings. Present and prior performance can be used to evaluate expectations about expected future performance(predictive value) and to compare actual performance with prior expectations (feedback value). According to SFAC No. 8, user interest in future cash flows necessitates that accountants provide information on current period efforts and accomplishments (earnings). Cash flow statements provide inadequate information to assess the amount and timing of future cash flows. Accrual accounting, not cash flow accounting, provide information which adequately reflects the financial effects on the enterprise of transactions and events that have cash consequences for the enterprise. Accrual accounting is concerned with the process of generating and expending cash, not the actual cash flows themselves. It recognizes that activities of a business which affect enterprise performance do not always coincide with the associated or resulting cash flow.

The income statement has value as a measure of future cash flows, as a measure of management efficiency in the use of enterprise resources and it provides feedback regarding the accomplishment of management objectives.

The income statement provides timely measurement of enterprise performance. The cash flow a subsequent accounting period. Timeliness would indicate that the expected cash flow effects of a transaction be captured in the accounting period when the transaction causing the eventual cash flow occurs. Accrual basis accounting does capture these effects. Cash basis accounting does not. A company could be in financial trouble. If it does not pay bills, it could show a positive cash flow. If so, the cash flow statement would not reveal the extent of the company’s financial difficulties. Accrual basis accounting would.

Debate 7-2 Fair (current) value vs. historical cost 103

Team 1 We believe that historical cost is relevant because it is objective and verifiable. Historical cost is not based on subjective estimations; rather it is the result of the value buyers and sellers have agreed to in an "arm's-length" transaction. As a result, historical cost is more reliable than current value. You can even argue that historical cost actually represents the present value of expected future cash flows at the time the exchange takes place. We also argue that historical cost is relevant based on the financial capital maintenance concept. Financial capital maintenance tracks the dollars invested in a company and the flow of those dollars as they are invested in assets which then return cash inflows to the company. Thus, we argue that historical cost allows that accountants serve a stewardship role, and because cost measures the actual resources exchanged, it is relevant to readers of financial statements. Conversely, current values may not be available for all balance sheet elements. So, its exclusive use would result in both good and bad reported values (i.e., inconsistent measures). Current values require preparers to estimate the amounts and timing of cash flows which are inherently uncertain. And, an appropriate discount rate is difficult to ascertain. In addition, reporting current values on the balance sheet would result in recording unrealized gain and losses on the income statement. This would be a contradiction to accounting’s realization principle and the long-standing concept of conservatism. Finally, because reporting historical cost is objective, it provides unbiased information to users. The resulting financial disclosures would not allow managerial bias in the selection of current costs. They would therefore provide a greater degree of transparency in financial reporting. Team 2 We believe that historical cost may be more objective, but that current costs are more relevant. We oppose the use of historical cost in favor of current cost because values do change over time and, consequently, that historical cost can lose its relevance as a valuation base. We argue that current cost measurement reflects current conditions, and, therefore, represents the current value to the firm. Current cost provides a better measure of a company’s liquidity because all current assets would be measured reflect resources available to cover current liabilities. Current costs are related to expected future cash flows. As such their use provides an approximation of the economic concept of income, the most relevant value to the users of financial statements. Current cost is also consistent with the physical capital maintenance concept of income. It provides a measure of the value of the company’s physical capital. Use of the physical capital maintenance concept allows the company to better survive in the long-run because income is reported only when there is a change in the amount of physical capital on hand. In short, we argue in favor of relevance to investors. We believe that even though current cost estimates may be subjective, they are more relevant than object, meaningless measures utilizing the historical cost concept. 104

WWW Case 7-9 a.

Yes, the loss represents a probably future sacrifice (payment to plaintiff) of economic resources (probably cash) of an entity (the company being sued) resulting from a prior transaction or event (the event that resulted in the plaintiff filing the law suit).

Yes, the gain represents a probable future benefit (inflow of assets from plaintiff) obtained or controlled by an entity resulting from a past transaction or event (event causing the lawsuit to be filed).

The primary reason for the difference is accounting conservatism. Accountants tend to recognize probable bad news but not probable good news. They are reluctant to overstate assets and income.

Case 7-10 a.

In September, 2007 the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement specifies how fair value is to be determined when such measurements are required by existing GAAP. It does not indicate when fair value measurements are to be used. The rationale for SFAS No.157 was that previous GAAP contained inconsistent definitions and only limited application guidance for fair value measurements. The most important aspects of SFAS No. 157 are: 1. A new definition of fair value. 2. A fair value hierarchy used to classify the source of information used in fair value measurements. (For example, market based or non-market based). 3. New disclosures of assets and liabilities measured at fair value based on their level in the hierarchy. 4. A modification of the presumption that the transaction price of an asset or liability equals its initial fair value. SFAS No.157 is to be applied to any asset or liability that is measured at fair value under current GAAP. The statement identifies 67 current pronouncements that refer to fair value that will be impacted by its provisions. It also identifies some measurements that are not affected by its provisions including those: (1) related to share-based payments, (2) based on (or that otherwise use) vendor-specific objective evidence of fair value and (3) related to inventory. SFAS No. 157 represents the FASB’s current position on the trade off between reliability and relevance of financial information. It also reflects the FASB’s conclusion that investors and creditors find fair value measurement relevant, even in the absence of exact market data. As a result, the trade off now favors relevance and financial statement users will need to be made aware of the quality of the information provided through meaningful and transparent disclosures in order to assess the relative reliability of the fair value measurements provided. Definition of Fair Value SFAS No. 157 defines “fair value” as: “…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition is exit price based. For an asset, fair value is the price at which it would be 105

sold. In contrast, an entry price for an asset is the price at which it would be bought. The exit price is to be used regardless of whether the entity plans to hold or sell the asset. Additionally, SFAS No. 157 specifies that fair value is market based rather than entity specific. As a result, fair values must be based on assumptions that market participants would use in pricing the asset or liability. Fair Value Hierarchy SFAS No 157 establishes a hierarchy that ranks the quality and reliability of information used to determine fair values. The following exhibit provides a description of the levels in the hierarchy and examples:

Hierarchy of the Quality and Reliability of Information Used to Determine Fair Values Level and Inputs Information used to determine fair value Level 1 — Quoted market prices for identical assets or liabilities in active markets Level 2 — Observable market-based inputs, other than Level 1 quoted prices (or unobservable inputs that are corroborated by market data)

Level 3 — Unobservable inputs (that are not corroborated by observable market data)

Examples Company A common stock traded and quoted on the New York Stock Exchange. Company B common stock traded and quoted only on an inactive market in an emerging country. A privately placed bond of Z whose value is derived from a similar Z bond that is publicly traded. An over-the-counter interest rate swap, valued based on a model whose inputs are observable LIBOR forward interest rate curves. A long-dated commodity swap whose forward price curve, used in a valuation model, is not directly observable or correlated with observable market data. Shares of a privately held company whose value is based on projected cash flows.

If the fair value of an asset or liability is based on information from more than one level of the hierarchy, the classification of fair value depends on the lowest level input with significant effect. For example, if a particular measurement contains both Level 2 and Level 3 inputs and both have a significant effect, then the measurement falls in Level 3.

Disclosures The disclosure requirements are designed to indicate the relative reliability of fair value measurements. SFAS No. 157 requires separate disclosures of items that are measured at fair value on a recurring basis (such as an investment portfolio versus items that are measured at fair value on a nonrecurring basis such as an impaired asset). Following are the major disclosures required at each annual and interim balance sheet date: 1.

For items that are measured on a non-recurring basis at fair value: A separate table for assets and for liabilities that displays the balance sheet fair value carrying amount of major categories of assets and of liabilities is required. Within each table, the assets and liabilities measured at 106

fair value in each major category are separated into the level of the hierarchy on which fair value is based. The table also includes total gains and losses recognized for each major category 2. For items that are measured on a recurring basis at fair value: Tables similar to those required for non-recurring items, and additional information regarding fair values based on Level 3 (unobservable) inputs, including a roll forward analysis of fair value balance sheet amounts and disclosure of the unrealized gains and losses for Level 3 items held at the reporting date is required SFAS No. 157 requires disclosures about the fair value measurements in a tabular format for each major category of assets and liabilities measured at fair value on a nonrecurring basis during the period. A table is also required for liabilities measured at fair value on a non-recurring basis, if any exist. A similar set of disclosures is to be made for assets and liabilities that are remeasured at fair value on a recurring basis. b.

The factors (which are not intended to be all inclusive) specified that indicate there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the same or similar assets or liabilities include: 1. There are few recent transactions. 2. Price quotations are not based on current information. 3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets). 4. Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability. 5. There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risks for the asset or liability. 6. There is a wide bid-ask spread or significant increase in the bid-ask spread. 7. There is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities. Little information is released publicly. The circumstances identified that may indicate that a transaction is not orderly include, but are not limited to: 1. There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions. 2. There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. 3. The seller is in or near bankruptcy or receivership (that is, distressed), or the seller was required to sell to meet regulatory or legal requirements (that is, forced). 4. The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

Case 7-11 a.

The main purpose of the statement of cash flows is to show the change in cash from one period to the next. Another objective of a statement of the type shown is to summarize the financing 107

and investing activities of the entity, including the extent to which the enterprise has generated cash or near cash assets from operations during the period. Another objective is to complete the disclosure of changes in financial position during the period. The information shown in such a statement is useful to a variety of users of financial statements in making economic decisions regarding the enterprise. b.

The following are weaknesses in form and format of Baines Corporation’s Statement of Sources and Application of Cash: 1. The title of the statement should be Statement of Cash Flows. 2. The statement should add back to (or deduct from) net income certain items that did not use (or provide) cash during the period. The resulting total should be described as net cash provided by operating activities. Cash flows from extraordinary items, if any, should be presented with appropriate modifications in terminology as investing or financing activities. The only apparent adjustments in this situation are the amounts to be added back to net income for the depreciation and depletion expense, for any wage or salary expense related to the employee stock option plans, and for changes in current assets and liabilities. 3. The format used should separate the cash flows into investing, financing, and operating activities. Noncash investing and financing activities, if significant, should be shown in a separate schedule or note. 4. Individual items should not be grouped together, as was the case for the $14,000 item.

1. The $25,000 option plan wage and salary expense should be included in the statement as an amount added back to net income, an expense not requiring the outlay of cash during the period. Since the statement balances and no reference is made to the $25,000 payroll expense, it appears the expense was not recorded or that there is an offsetting error elsewhere in the statement. 2. The expenditures for plant-asset acquisitions should not be reported net of the proceeds from plant-asset retirements. Both the outlay for acquisitions and the proceeds from retirements should be reported as investing activities. The details provide useful information about changes in financial position during the period. 3. Stock dividends or stock splits need not be disclosed in the statement because these transactions do not significantly affect financial position. 4. The issuance of the 16,000 shares of common stock in exchange for the preferred stock should be shown as a noncash financing activity. Since these transactions significantly change the corporation’s capital structure, they should be disclosed. 5. The presentation of the combined total of depreciation and depletion is probably acceptable. The general rule is that related items should be shown separately in proximity when the result contributes information useful to the user of the statement, but immaterial items may be combined. In this situation, it is likely that no additional relevant information would be added by showing depletion as a separate item. The total should be added back to net income in the computation of the net cash flow from operating activities. 6. The details of changes in long-term debt should be shown separately. Payments should not be netted against increases in long-term borrowings. The long-term borrowing of $620,000 should be shown as cash provided and the retirement of $441,000 of debt should be shown as use of cash from financing activities.

Case 7-12 108

The Boards propose to further disaggregate assets and liabilities within each category into shortterm and long-term based on a one-year time frame that would replace the current distinction between current and non-current assets and liabilities that uses a one year or the operating cycle criterion. Assets and liabilities presented within each section would be further analyzed as shortterm and long-term, unless presenting assets and liabilities in order of liquidity would provide more relevant information. In a presentation based on liquidity, an entity should present its assets and liabilities in increasing or decreasing order of liquidity, and it should include in the notes to its financial statements information about the maturities of its short-term contractual assets and liabilities. Additionally, entities should present information about the maturities of their long-term contractual assets and liabilities in the notes to financial statements. The Boards also propose that cash equivalents be considered similar to short-term investments and presented separately from cash. As discussed in the chapter, cash equivalences currently are aggregated with cash since both FASB and IASB have considered that cash equivalents are highly liquid and to be essentially the same as cash. However, the Boards concluded that excluding cash equivalents from the amount of cash presented in the statement of financial position would better help to achieve the liquidity and financial flexibility objective since shortterm investments do not have all the characteristics of currency on hand and are subject to some risk of price change such as those attributable to sudden changes in the credit environment as occurred in 2007-8. Case 7-13 The solution to this case depends upon the companies selected. Requiring the students to print the relevant information from the financial statements is a good method to use to check their answers. Case 7-14 Presentation of Comprehensive Income . The answer to this case depends on the companies selected by the students. Financial Analysis Case The answer to this case depends on the companies selected by the students.

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CHAPTER 8

Case 8-1 a.

Trading securities - Securities held for resale Securities available-for-sale - Securities not classified as trading securities or held-to-maturity securities. Securities held-to-maturity - Securities for which the reporting enterprise has both the positive intent, and ability to hold to maturity. Trading securities are reported at fair value, and all unrealized holding gains and losses are also reported at fair value and included in periodic net income. Available-for-sale securities are reported at fair value; however, unrealized holding gains and losses for these securities are not included in periodic net income, rather they are reported as comprehensive income until realized. Held-to-maturity securities are accounted for by the historical cost the security's maturity value, is amortized over the remaining life of the security.

Trading securities are reported as current assets on the balance sheet. Individual held-tomaturity and available-for-sale securities are reported as either current assets or investments as appropriate.

The individuals supporting current value maintain that all gains and losses affecting the company during an accounting period that can be measured should be recorded and reported. Since current values are generally available for marketable securities, proponents of current value accounting hold that these current values should be reported on the annual financial statements. The individuals who fear that current value accounting might allow earnings management are concerned about gains trading. A manager using a gains trading strategy would transfer securities that have declined in value to a long-term asset account and retain those securities that have increased in value under the temporary investment category.

Case 8-2 a.

The average cost method is based on the assumption that the average costs of the goods in the beginning inventory and the goods purchased during the period should be used for both the inventory and the cost of goods sold. The FIFO (first-in, first-out) method is based on the assumption that the first goods purchased are the first sold. As a result, the inventory is at the most recent purchase prices, while cost of goods sold is at older purchase prices.

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The LIFO (last-in, first-out) method is based on the assumption that the latest goods purchased are the first sold. As a result, the inventory is at the oldest purchase prices, while cost of goods sold is at more recent purchase prices. b.

In an inflationary economy, LIFO provides a better matching of current costs with current revenues because cost of goods sold is at more recent purchase prices. Net cash inflow is generally increased because taxable income is generally decreased, resulting in payment of lower income taxes.

Where there is evidence that the utility of goods to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at market value in the financial statements. In accordance with the concept of conservatism, inventory should be valued at the lower of cost or market.

Case 8-3 a.

Inventory cost should include all reasonable and necessary costs of preparing inventory for sale. These costs include not only the purchase price of the inventories, but also the other costs associated with readying inventories for sale.

The lower of cost or market rule produces a realistic estimate of future cash flows to be realized from the sale of inventories. This is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs.

Steel's inventories should be reported on the balance sheet at market. According to the lower of cost or market rule, market is defined as replacement cost. Market cannot exceed net realizable value and cannot be less than net realizable value less the normal profit margin. In this instance, replacement cost is between net realizable value and net realizable value less the normal profit margin. Therefore, market is established as replacement cost. Since market is less than original cost, inventory should be reported at market.

Ending inventories and net income would have been the same under either lower of average cost or market or lower of FIFO cost or market. In periods of declining prices, the lower of cost or market rule results in a write-down of inventory cost to market under both methods, resulting in the same inventory cost. Therefore, net income using either inventory method is the same.

Case 8-4 a.

The direct write-off method overstates the trade accounts receivable on the balance sheet by reporting them at more than their net realizable value. Furthermore, because the write-off often occurs in a period after the revenues were generated, the specific write-off method does not match bad debts expense with the revenues generated by sales in the same period.

One allowance method estimates bad debts based on credit sales. The method focuses on the income statement and attempts to match bad debts with the revenues generated by the sales in the same period.

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The other allowance method estimates bad debts based on the balance in the trade accounts receivable accounts. The method focuses on the balance sheet and attempts to value the accounts receivable at their future collectible amounts. c.

Anth should account for the collection of the specific accounts previously written off as uncollectible as follows: * *

Correction of allowance account by debiting accounts receivable and crediting allowance for doubtful accounts. Collection of specific accounts previously written off as uncollectible by debiting cash and crediting accounts receivable.

Anth should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period July 1, 2013 through December 31, 2013, on its December 31, 2013, balance sheet as current assets. Both assets are due on June 30, 2014, which is within one year of the date of the balance sheet. Anth should report interest income from the notes receivable on its income statement for the years ended December 31, 2013 and 2014. The interest income would be equal to the amount accrued on the notes receivable at the stated rate for six months in 2013. Interest accrues with the passage of time, and it should be accounted for as an element of income over this period. The remaining six months of interest will be reported on Arth’s December31,2014 income statement.

Case 8-5 a.

Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means, in principle, the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production.

Market, as applied to the valuations of inventories, means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume which is usually purchased by the company. The term is applicable to inventories of purchased goods and to the basic elements of cost (materials, labor and overhead) of goods that have been manufactured. Therefore, market means current replacement cost except that it should not exceed the net realizable value (estimated selling price less predicted cost of completion and disposal) and should not be less than net realizable value reduced by an allowance for a normal profit margin.

The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required, however, when the utility of the goods included in the inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower of cost or market rule arose from the accounting convention of providing for all losses and anticipating no profits.) 112

In accordance with the foregoing reasoning the rule of "Cost or market, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly interprets operations The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product alternative procedures are suitable. d.

The arguments against the use of the lower of cost or market method of valuing inventories include the following: 1. The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over replacement cost) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization a drop in selling price below cost is no more a sustained loss than a rise above cost is a realized gain. 2. A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-down is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer. 3. The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances. 4. The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost one year end and at market at the next year end. 5. The lower of cost or market method values the inventory on the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize.

Case 8-6 a.

The use of the allowance method based on credit sales to estimate bad debt is consistent with the matching principle because bad debts arise from and are a function of making credit sales. Therefore, bad debt expense for the current period should be matched with current credit sales. This is an income statement approach because the balance in the allowance for bad debts account is ignored when computing bad debt expense. The allowance method based on the balance in accounts receivable is not consistent with the matching principle. This method attempts to value accounts receivable at the amount expected to be collected. The method is facilitated by preparing an aging schedule of accounts receivable and plugging bad debt expense with the adjustment necessary to bring the allowance account to the required balance. Alternatively, the ending balance in accounts receivable can be used to determine the required balance in the allowance account without preparing an aging schedule by using composite percentage. Bad debt expense is then determined in the same manner as when 113

an aging schedule is used. However, neither of these approaches associates bad debt expense with the period of sale, especially for sales made in the last month or two of the period. b.

On the balance sheet, the allowance for bad debts is presented as a contra asset account to accounts receivable with the resulting difference representing the accounts receivable net (i.e., their net realizable value). Bad debt expense would generally be included on Carme's income statement with the other operating (selling/general and administrative) expenses for the period. However, theoretical arguments can be made for (1) reducing sales revenue by the bad debts adjustment in the same manner that sales returns and allowances and trade discounts are considered reductions of the amount to be received from sales of products or (2) classifying the bad debts expense as a financial expense.

Case 8-7 a.

During the first year Key should report the securities at $550,000 on the balance sheet under the long-term investment category (Original cost of $500,000 and an increase in market valuation of $50,000. (It is possible that some of the portfolio could be disclosed as a current asset if Key plans on selling some of its investment during the next year.) This $50,000 increase in market valuation would be disclosed on Key’s financial statements as an increase in other comprehensive income. During the second year Key should disclose the securities at $475,000 on the balance sheet under the long-term investment category. Since the original cost of the investments remaining at the end of year 1 was $475,000, the cost balance indicates that additional investments of $105,000 (500,000- 80,000-525,000) were purchased in year 2). The decrease in market valuation will be reported on Key's financial statements as a $95,000 decrease in other comprehensive income ($550,000 – 30,000 + 50,000 - 95,000). Additionally, Key should report a gain on the sale of investments of $20,000 during the second year ($100,000 – 80,000). The previously recorded increase in value was reported as an increase in other comprehensive income and is removed from that category and classified as a gain at the time of the sale).

If these securities had been categorized as trading securities, the asset valuations and method of reporting on the balance sheet will be the same as Part (a) except that the securities will be disclosed under the current assets section of the balance sheet instead of the long-term investments section. In the first year Key will report an unrealized gain of $50,000 on its income statement ($550,000 - 500,000). In the second year Key will report an unrealized loss of $95,000 on its income statement. Key will not record a gain on the sale of the securities in the second year because this gain was reported as an unrealized gain on Key’s income statement in the first year.

Case 8-8 a.

Arguments for the specific identification method are as follows: (1)

It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price.

(2)

The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs.

(3)

Inventory is valued at actual cost instead of an assumed cost 114

Objections to the specific identification method include the following:

(1)

The cost of using it-restricts its use to goods of high unit value.

(2)

The method is impractical for manufacturing processes or cases in which units are commingled and identity lost.

(3)

It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogenous group.

(4)

It may not be a meaningful method of assigning costs in periods of changing price levels.

The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which occurred. As a result the inventories are stated at the latest costs. When the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported profit is not fully available since a part of it must be used to replace inventory at a higher cost. The results achieved by weighted average method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the weighted average has the advantage that the goods need not be individually identified; therefore accounting is not so costly and the method can be applied to fungible goods. The weighted average method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it be assumed that actual cost is the appropriate method of valuing inventories, last-in, first-out is not theoretically correct. In general, LIFO is directly adverse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported profit figures because it eliminates paper profits and losses on inventory and smoothens the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figure can be artificially 115

influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. Case 8-9 a.

According to SFAC 5, net realizable value is the nondiscounted amount of cash, or its equivalent, into which an asset is expected to be converted in the future net of direct costs, if any, necessary to make the conversion.

The balance sheet approach to estimating bad debts provides the better estimate of net realizable value. Aging reports receivables measured in terms of how much is expected to be collected from subsets of the receivables categorized by age. Older receivables would be expected to yield proportionately less cash than more recent receivables. The income statement approach does not purport to measure how much is expected to be collected from the receivables. Rather it measures how much is expected to be uncollectible from a given years sales.

ii.

Liquidity is the ability to pay current debt and continue operations. Working capital is the difference between current assets and current liabilities. The balance sheet approach to measuring bad debts would be more useful in providing a measure of liquidity. As stated above this approach provides a better estimate of net realizability and hence the amount of cash that would be available to pay current liabilities.

iii. The income statement approach provides better matching. The matching concept implies that revenues should be matched with the cost of generating them. Estimating bad debts based on net sales attempts to subtract from sales those that will not be collected thereby matching them with cost, those that will not realize cash. iv.

The balance sheet approach is more consistent with the definition of comprehensive income. Comprehensive income is the change in net assets occurring during the accounting period for non-owner transactions. The balance sheet approach provides a direct measure of those changes and hence a direct measure of the effect of those changes on comprehensive income.

The income statement approach is more consistent with financial capital maintenance. It provides a direct measure of the effect of transactions, sales, on future cash flows.

vi.

The balance sheet approach is more consistent with physical capital maintenance because it provides balance sheet measures which are closer to current value.

Case 8-10 a.

.i.

Short-term prepaids are classified as current assets because they will be consumed during the current operating cycle or one year whichever is longer. These assets will not be converted into cash. Rather, they would require the use of cash in the near future had cash not already been expended.

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Prepaids meet the definition of assets found in the conceptual framework because they will provide future benefit. For example, prepaid rent is an asset. The right to use an asset, say office space, was paid for in advance. That payment provides future benefit: the use of the asset over some future time period. Prepaids do not provide working capital in the usual sense of the definition of working capital. Working capital is a measure of the ability of the firm to pay currently maturing debt. Since prepaids will not generate cash, they will not be used to pay debt. However, it may be argued that they indirectly provide liquidity because the services which have already been paid for are needed for operations. If they had not already been paid for, they would require the use of cash which would decrease the firm’s ability to pay current debt. ii. The most convincing argument for excluding prepaids from working capital is that they will not provide cash to pay currently maturing debt. They have no net realizable value. If not, it is difficult to say that prepaids provide liquidity. b.

Accountants include short-term unearned revenues as current liabilities because they will be earned by performing services during the current operating cycle or year whichever is longer. The conceptual framework defines liabilities as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as the result of prior transactions or events. Yes, unearned revenues meet the definition of liabilities. They are present obligations to provide services to other entities in the future as a result of prior transactions or events (the receipt of cash from an arm’s length transaction). Since they are classified as current liabilities, current unearned revenues decrease working capital. However, they will not require the expenditure of current assets.

Current liabilities are defined as liabilities that will be paid out of current assets or replaced by other current liabilities. Current unearned revenues will not be paid with cash or any other assets. Moreover, they will not be replaced by other current liabilities. And if the purpose of classification of liabilities as current is to provide measures of liquidity, it is difficult to see how a liability that will not be paid affects liquidity.

FASB ASC 8-1 Current Assets and Current Liabilities Information on the disclosure of current assets and current liabilities is found at FASB ASC 210. It can be accessed by searching the glossary for current assets and current liabilities. The relevant information is found at 210-10-45. After accessing the topic use the printer friendly with sources option . FASB ASC 8-2 Offsetting Assets and Liabilities Search offsetting assets and liabilities Found at 210-20 Us printer friendly with sources option after accessing the topic FASB ASC 8-3 Inventory 117

The objective of accounting for inventory is found at FASB ASC 330-10-10. Search “objective of accounting for inventory.” Found at FASB ASC 330 Inventory > 10 Overall > 10 Objectives Use the printer friendly with sources option to find the original source. FASB ASC 8-4 Examples of Current Assets From topic list select Presentation and Balance Sheet. Found under Other Presentation Matter Classification of Current Assets Topic 210-10-45 FASB ASC 8-5 Classification of Current Liabilities From topic list select Presentation and Balance Sheet. Found From topic list select Presentation and Balance Sheet. Found under Other Presentation Matter Classification of Current Liabilities Topic 210-10-45 FASB ASC 8- 6 Compensating Balances Search compensating balances Found at 210-10-S99 FASB ASC 8-7 SFAS 115 Cross Reference FAS 115. Found at 320-10 Investments-Debt and Equity Securities. FASB ASC 8-8 ARB 43 and Inventory Found through Cross Reference.ARB 43 Topic 330-10-05 Use printer friendly with sources option to find relevant items.

Room for Debate Debate 8- 1 Team 1

Defend LIFO

Cost of goods sold if the purchase is postponed until 2015: Beginning Inventory: First Layer Second Layer

10,000 x $15 22,000 x $18 118

$ 150,000 396,000

Purchases Available Sold Ending Inventory Cost of Goods Sold

250,000 x $20 282,000 (245,000) 37,000

5,000,000 $5,546,000 646,000 $4,900,000

Cost of goods sold if the purchase is made in 2014: Available from above Additional Purchase Available Sold Ending Inventory Cost of Goods Sold

282,000 40,000 x $17 322,000 ( 245,000) 77,000

$5,546,000 680,000 $6,226,000 1,446,000 $4,780,000

Difference

$ 120,000

Calculation of ending inventory: Purchase in 10,000 x $15 22,000 x $18 5,000 x $20 45,000 x $20 Ending Inventory Cost of sales Purchase in 40,000 x $17 205,000 x $20 245,000 x $20

2014 150,000 $ 396,000

1,446,000

$ $

The difference: 40,000 x ($20-17)

2014 680,000 4,100,000 4,780,000 =

2015 150,000 396,000 100,000 900,000 646,000

2015

4,900,000 120,000

The use of LIFO allows MVP to expense 40,000 units as cost of sold at $17 rather than $20, thereby lowering cost of sales by $120,000 if the purchase is made in 2014. This shows that management can manipulate earnings under LIFO simply by choosing when to purchase. Even though it is obvious that these items were not sold or consumed during the period. This makes the income statement look better than it otherwise would. Hence, for MVP the use of LIFO has value. To management, it could mean a bigger bonus. The use of LIFO is based on the assumption that current costs should be matched against it. Although LIFO does not use current cost, the most recent costs are used to calculate cost of sales; hence, LIFO yields the closest approximation to current value of any cost based method of inventory valuation. As such, it provides the closest historical cost measure of “real income” and is consistent with the concept of physical capital maintenance. In addition, LIFO may eliminate inventory holding gains when the inventory remains stable from year to year, and the use of LIFO when prices are rising reduces taxable income and hence, the payment of income tax. 119

LIFO is better than FIFO because during inflation, FIFO results in matching older, lower cost against revenues. The result is inflated profits that could be misleading to inventors, creditors and other users. Inflated profits can result in the payment of additional income taxes and it makes it appear as though the company has more available to distribute in dividends than it should. Team 2 Defend FIFO Cost of goods sold under FIFO would be the same regardless of whether the inventory were purchased in 2014 or 2015 because sales would be calculated using old costs, and would not be affected by recent purchases. The following calculations are made under the assumption that the inventory layers result from the application of FIFO. Cost of goods sold if the purchase is postponed until 2015: Beginning Inventory: First Layer Second Layer Purchases Available Sold Ending Inventory Cost of Goods Sold

10,000 x $15 22,000 x $18 250,000 x $20 282,000 (245,000) 37,000

$150,000 396,000 5,000,000 $5,546,000 740,000 $4,806,000

Cost of goods sold if the purchase is made in 2014: Available from above Additional Purchase Available Sold Ending Inventory Cost of Goods Sold

282,000 40,000 x $17 322,000 ( 245,000) 77,000

Difference

$5,546,000 680,000 $6,226,000 1,42000 $4,806,000 $

Calculation of ending inventory: Purchase in 37,000 x $20 40,000 x $17 Ending Inventory Cost of sales Purchase in 10,000 x $15 22,000 x $18 213,000 x $20

2014 $ 740,000 680,000 $1,420,000

2015 $ 740,000

2014 $ 150,000 396,000 4,260,000 $4,860,000

2015 $ 150,000 396,000 4,260,000 $4,860,000

120

$ 740,000

The use of FIFO satisfies the historical cost principle. The valuation of flows is consistent with the typical actual flow of goods. It also satisfies the matching principle since the historical cost is matched with revenue. And, inventory valuation on the balance sheet more closely resembles replacement cost because it comprises recent prices. This allows users to better evaluate future cash flows to replace the inventory. An added advantage of FIFO over LIFO is demonstrated by this case. It is not possible to manipulate cost of sales by the use of FIFO, while manipulation is obviously possible under LIFO. Hence, the use of FIFO would satisfy the qualitative characteristic of neutrality. Debate 8-2 Components of working capital Team 1 A company’s working capital is the net short-term investment needed to carry on day-to-day activities. Since inventory is used in day-to-day activities it should be included. The inventory must be sold to generate cash flow. If anything we could argue that because inventory is reported at cost, it is actually undervalued, but it would not follow that it should be excluded. Except for a few industries (such as breweries) that have long operating cycles, companies typically turn their inventory many times during the year, continuously providing operating cash inflows to pay currently incurred short term obligations. Paton argued that a fixed asset will remain in the enterprise two or more periods, whereas current assets will be used more rapidly; fixed assets may be charged to expense over many periods, whereas current assets are used more quickly; and fixed assets are used entirely to furnish a series of similar services, whereas current assets are consumed. Therefore, all assets that meet the definition of current assets, should be included in calculating working capital The working capital concept provides useful information by giving an indication of an entity’s liquidity and the degree of protection given to short-term creditors. Specifically, the presentation of working capital can be said to add to the flow of information to financial statement users by (1) indicating the amount of margin or buffer available to meet current obligations, (2) presenting the flow of current assets and current liabilities from past periods, and (3) presenting information on which to base predictions of future inflows and outflows. In the following sections, we examine the measurement of the items included under working capital. Prepaid expenses have been included as current assets because if they had not been acquired, they would require the use of current assets in the normal operations of the business Team 2 Current U.S. and international practice is based on the assumption that the items classified as current assets are available to retire existing current liabilities and that the measurement procedures used in valuing these items provide a valid indicator of the amount of cash expected to be realized or paid. Closer examination of these assumptions discloses two fallacies: (1) not all the items are measured in terms of their expected cash equivalent, and (2) some of the items will never be received or paid in cash. However, prepaids will be used rather than exchanged for cash and, therefore, do not aid in predicting future cash flows. 121

If the working capital concept is to become truly operational, it would seem necessary to modify it to show the amount of actual buffer between maturing obligations and the resources expected to be used in retiring them. Such a presentation should include only the current cash equivalent of the assets to be used to pay the existing debts. It would therefore seem more reasonable to base the working capital presentation on the monetary–nonmonetary dichotomy used in price level accounting (See Chapter 17.) because monetary items are claims to or against specific amounts of money; all other assets and liabilities are nonmonetary. The monetary working capital presentation would list as assets: cash, cash equivalents, temporary investments, and receivables and would list as liabilities current payables. It would not include inventories, prepaid assets or deferred liabilities. Also more meaningful information could be provided if all temporary investments were measured by their current market price, including securities held to maturity. This presentation would have the following advantages: (1) it would be a more representative measure of liquidity and buffer because it would be more closely associated with future cash flows, (2) it would provide more information about actual flows because only items expected to be realized or retired by cash transactions would be included, and (3) it would allow greater predictive ability because actual cash flows could be traced. Debate 8-3 Capitalization vs expense Team 1: Present arguments for capitalizing all of the above costs. Your arguments should utilize the Conceptual Framework definitions and concepts.

The primary argument in favor of capitalizing all of the costs is the historical cost principle. According to the historical cost principle, the historical cost of an asset is all costs that it takes to acquire the asset and get it ready for its intended use. To apply the historical cost principle to an item, it must first meet the definition of an asset. We argue that all of these costs (the purchase price of the property, the cost to remove the building, the cost to remove the tanks and refine the soil) are necessary to acquire the site for the restaurant and thus will provide future economic benefit. We also argue that the cost to construct the building, as well as the cost of the avoidable interest that was incurred during construction, were necessary to acquire the building and get it ready for its intended use. Thus, they should all be capitalized as part of the historical cost of the assets land and building. SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction. Without question, the acquisition of the site for the restaurant meets this definition of an asset. It will provide a future economic benefit because the restaurant will be built there and is intended to generate a profit for its owner(s). No one would argue that the purchase price of $900,000 should be capitalized as part of the asset’s cost. In addition it has been standard accounting practice (and thus a part of GAAP) that the $30,000 cost to remove a building is a part of getting the land ready for its intended use and thus should be capitalized as land, along with the purchase price. In addition, Entre is required by the government to remove underground tanks and to refine the soil. The cost to remove the tanks is $40,000 and the cost to refine the soil is $30,000. Like the cost incurred to remove the building these costs are necessary to get the land ready to build the 122

building. Without incurring these costs, Entre cannot build the restaurant and will not be able to receive future benefits (return) from his investment. Thus, we argue that these costs meet the definition of an asset and are consistent with the historical cost principle. Obviously, the $1,800,000 cost incurred to construct the building to house the restaurant should be capitalized as part of the building cost. The building is arguably an asset. It will be used as Entre’s place of business where his employees will prepare and serve food to customers. Thus, it meets the definition of an asset because it provides a probable future benefit. In addition, the FASB determined in SFAS No. 34, that avoidable interest incurred to construct an asset, such as Entre’s restaurant, should be capitalized as a part of the cost of the asset. It is a necessary cost to construct the asset because had the asset not been constructed the debt used to finance the construction and thus the cost of borrowing (interest) could have been avoided. Because it could have been avoided, the interest is deemed to be necessary to acquire the asset and get it ready for its intended use. Thus, capitalization of $22,000 of avoidable interest incurred during construction as part of the asset’s cost is consistent with the historical cost principle. Team 2:

Criticize capitalization of the cost to remove the tanks and refine the soil and the capitalization of interest during construction. Do they provide added service potential? Your arguments should utilize the Conceptual Framework definitions and concepts

We believe that neither the costs of removing the tanks and refining the soil nor the cost of avoidable interest incurred during construction of the restaurant should be capitalized and reported as costs of assets. Our argument is based primarily on the position that these expenditures do not add future service potential to the land or to the building. Thus, they do not meet the definition of an asset. This means that if we report these costs as assets we would be violating the qualitative characteristic of representational faithfulness. We would be reporting a non-asset as an asset. Thus, it would not be what it purports to be. SFAC No. 6 defines an asset as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction. Neither removing the tanks at a cost of $40,000 nor incurring a $30,000 expenditure to refine the soil once the tanks are removed does not increase the expected future cash inflow from the operation of the restaurant. Thus, it provides no future benefit and is not an asset. Furthermore, if we were to purchase an identical adjacent site that does not have a service station on it, the current site would not be more valuable than the adjacent site. Since both sites could be used to generate the same future cash flows and profit, one is not more valuable than the other. As a result, if we were to capitalize the costs of removing the tanks and refining the soil, we contend that the historical cost of the land would be overstated. Is not the initial value of an asset equivalent to the present value of the future cash flows expected from its use? With regard to the capitalization of the $22,000 of “so called” avoidable interest that is incurred during construction, we can make similar arguments. It does not add to the future service potential of the building because it has no impact on the future cash flows or profit expected from the building’s use and thus does not add to its value. Moreover, the source of financing has nothing to do with the cost or value of the asset itself. Modern finance theory would separate the two. What would make a building financed with debt more valuable than a building that was financed with equity? Nothing would. If Entre financed the building with equity it would produce the same future cash flows as it would if he financed it with debt. Moreover, we could 123

argue that the cost of financing with equity is potentially more expensive than the cost of financing with debt. Due to the riskiness associated with uncertain returns to investors, the return on an equity investment is generally higher than the company’s incremental borrowing rate. We argue that if capitalization of avoidable interest should be added to the cost of the asset, then so should the avoidable cost of capital that is effectively incurred when financing the construction with equity. WWW Case 8-12 a.

If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Zippy Enterprises should include in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time.

Freight-in expenditures should be considered an inventoriable cost because they are part of the price paid or the consideration given to acquire the asset.

Theoretically the net approach is the more appropriate because the net amount (1) provides a correct reporting of the cost of the asset and related liability and (2) presents the opportunity to measure the inefficiency of financial management if the discount is not taken. Many believe, however, that the difficulty involved in using the somewhat more complicated net method is not justified by the resulting benefits.

Products on consignment represent inventories owned by Zippy Enterprises, which are physically transferred to another enterprise. However, Zippy Enterprises retains title to the goods until their sale by the other company (Touk Inc.). The goods consigned are still included by Zippy Enterprises in the inventory section of its balance sheet. Frequently the inventory is reclassified from regular inventory to consigned inventory

Case 8-13 The gross method of recording inventory is easy to apply. Purchases are recorded at the gross price. When a discount is taken, it is recorded as discounts taken. However, at the end of the accounting period, net purchases will be overstated unless adjusted for discounts that are expected not to be taken. Also, this method does not take into consideration that the discount theoretically represents interest on the net amount borrowed. Finally, the method does not highlight the cost of not taking discounts. The net method is also easy to apply. Purchases are recorded net of the discount. The theoretical justification is that discounts not taken are due to the passage of time and hence are more like interest on borrowed funds. The net method treats discounts not taken as interest expense. Also, the net method allows for better management control by reporting the cost of borrowing (the discount lost) separately. At the end of the accounting period, an adjustment should be made for the estimated discounts that will be lost. Case 8-14

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In IAS No. 2, the IASB held that the objective of inventory reporting is to determine the proper amount of cost to recognize as an asset and carry forward until the related revenues are recognized. The board stated a preference for the specific identification method of inventory valuation when the items are interchangeable or are produced and segregated for specific projects. This method was viewed as inappropriate when large numbers of interchangeable items are present. In these cases the IASB stated a preference for either FIFO or weighted average methods; however, LIFO was an allowed alternative. Under the revised IAS No. 2, the use of LIFO is no longer allowed. Additionally, under IAS N0. 2, inventory is to be measured at the lower of cost or net realizable value (estimated selling price less estimated costs of completion and sale). Inventory write-downs are calculated using net realizable value on an item-by-item basis, but allows write-downs to occur by groups of similar products in special circumstances.. IAS No. 2 requires inventory to be written down to net realizable value (floor) on an item-byitem basis, but allows write-downs to occur by groups of similar products in special circumstances. This contrasts to U. S. GAAP under which write-downs are normally determined either on an item-by-item, group, or categorical basis. Also, IAS No 2 allows previous inventory write-down reversals to be recognized in the same period as the write-down; whereas, any inventory write-downs under U.S. GAAP cannot subsequently be reversed. As the FASB and the IASB move toward convergence of accounting standards, the LIFO issue will need to be resolved. Although the process of converging U.S. GAAP with international GAAP has made a great deal of progress, there are still many issues yet to be addressed, including the fate of the LIFO method. For over a decade, FASB and the IASB have had an ongoing agenda of projects, the objective of which is to move the process of convergence forward. For the period 2006–2008, numerous convergence-related issues were identified as either being on an active agenda or on a research agenda prior to being added to an active agenda. However, the issues of LIFO and inventory valuation in general are not included on the active or the research agenda of either board. Case 8-15 Answer will depend on companies selected. Financial Analysis Case Answer will depend on company selected.

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CHAPTER 9 Case 9-1 a.

Under FASB ASC 958-605, the land would be recorded at fair value. The inflow is considered revenue. The land would be reported in the balance sheet at $100,000. A corresponding amount of revenue would appear in the income statement.

.i. FASB ASC 958-605 defines a donation as a nonreciprocal transfer. Recording the land at fair value is consistent with the full disclosure principle. It is also consistent with the Conceptual Framework's qualitative criterion, relevance. If users wish to value the firm, fair value of firm assets is relevant to their decision models. The primary defense of recording a donated asset at fair value is that fair value represents the cash equivalent value of the asset. If cash had been received, instead, the dollars would have been recorded. Then the dollars received could have been used to purchase the asset at fair value. Recording the inflow as revenue is consistent with the Conceptual Framework's definition of earnings, as the change in net assets from nonowner sources. The asset was received from a third party, not an owner. Its inflow adds value to the firm.

ii.

Recording the donated asset at fair value is inconsistent with the cost principle. According to the cost principle, the recorded cost of an asset is equivalent to the consideration given in return. Because a donation is a nonreciprocal transfer, nothing was given in return, hence, no cost can be recorded. A second, though less convincing argument, would be that fair value may be too subjective to be reliable. It can also be argued that if fair value is the appropriate and relevant measurement for a donated asset, then the credit should be considered a gain, not a revenue. The Conceptual Framework defines revenues as inflows from the production or delivery of goods and services. A donated asset does not result from the production or delivery of goods or services. Rather it is more like a gain - resulting from peripheral or incidental transactions.

Under previous practice, the credit for fair value of the donated asset would have been to donated capital. Because the credit to revenue required under FASB ASC 958-605 is closed to retained earnings, the composition of stockholders' equity would differ but total stockholders' equity is unaffected by the SFAS No. 116 requirements. Comparative balance sheets containing summary information would appear the same as before, as follows: ASSETS (800,000 + 100,000)

$900,000

S/E

LIABILITIES $350,000 550,000

Hence, balance sheet ratios such as debt/equity are not affected. 126

Placing the inflow of fair value on the income statement would increase income from continuing operations, net income and EPS. Case 9-2 a.

Postponing the purchase of the equipment until the next year will have the following financial statement impacts assuming that the equipment will be placed into use when it is purchased: Balance Sheet: Plant assets will be less by Cost Less Accumulated Depr ((400,000/10) x 1/2)

$400,000 20,000

$380,000

Notes Payable will be less by

$400,000

Interest Payable will be less by ((400,000/10) x 1/4)

10,000

Deferred Tax Liability will be less by Accumulated Depr tax (400,000 x 2/7 x 1/2) Accumulated Depr books Temporary difference

$57,143 20,000 $ 37,143x tax rate

Income Statement: Interest Expense will be less by

$10,000

Depreciation Expense will be less by

$20,000

Income Tax Expense will be more by the tax rate times lost interest and depreciation tax shield (tax rate x ($10,000 + 57,143)) and less by the change in the deferred tax liability (tax rate x $37,143). Statement of Cash Flows: The inflow from Operating Activities will be affected by the tax savings on the interest and depreciation taken on the tax return. The supplemental schedule disclosing financing and investing activities not affecting cash will include the purchase of the machine with the note. According to the efficient market theory, the only impact that postponing the purchase would have on stock price would result from cash flow impacts. These are described in part b. Finance theory on capital structure would suggest that the lower debt to equity ratio that would result from the postponement would imply less risk, because the debt to equity ratio is thought to 127

be correlated with the firm's beta. If the debt to equity ratio is significantly affected, the market could perceive the increased risk in a negative manner. b.

The cash flow impacts of postponing the purchase of the equipment comprise the time value of the tax effects of the interest and depreciation tax shields which total $77,143 ($20,000 + $57,143). Although the purchase would only be delayed three months, the first year depreciation is taken one year earlier and one fourth of the first year's interest is taken earlier. On the downside, the interest payments and the payment of principal are both shifted three months earlier. However, this shift is unlikely to have a material impact.

Purchasing before year-end would be more favorable to stockholders. The market assesses the value of the firm in terms of the present value of future cash flows. The depreciation and interest tax shields that would occur during the current year would accelerate the tax benefits of these deductions for one year. The timing of the interest and loan principal payment would occur three months earlier. But, the tax timing difference would produce a more significant effect.

Case 9-3 a.

The conventional concept of depreciation accounting usually is defined as a system of accounting that aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year.

This is a static concept of depreciation in which the initial cost or other value is not changed during the life of the asset; thus total depreciation charges over the life of the asset are equal to the initial cost or value of the asset less any salvage value. This concept is based upon the cost, realization and matching concept of conventional financial accounting. Cost represents the amount that is recorded as the value of the asset to the entity at the date of acquisition. In subsequent periods cost less accumulated depreciation is considered to represent the minimum value to the entity of the services to be received from the plant asset during the remainder of its life. The realization concept requires that during the life of an asset its valuation should not be greater than cost or cost less accumulated depreciation; if a higher valuation were recorded, the entity would recognize unrealized income.

ii.

The matching concept requires that the portion of the cost (or value basis) of the asset to be allocated to each accounting period should be matched with the expected revenue or net revenue contribution of the period. Matching can take the form of (1) adjusting depreciation charges for the effects of interest during the entire life of the asset, (2) associating depreciation allocations with net revenue contributions of the asset so that they are proportional to the net revenue contributions of each period, (3) associating depreciation allocations with nonmonetary, physical service units (e.g., input or output measures, such as machine-hours or miles of operation or number of units produced) so that they are proportional to the units of service provided each period or (4) associating depreciation allocations with units of time (e.g., months or years) so that they are equal for periods of equal length. 128

iii.

Since this concept merely requires that the allocation be systematic and rational, much discretion is left to management in the selection of a depreciation method. But the requirement that the allocation be rational probably means that it should be related to the expected benefits to be received from the asset. Since the conventional accounting concept of depreciation is a process of cost allocation, not valuation, the concern here is with determining what portion of the cost of the computer system should be assigned to expense in a given accounting period. The estimate of periodic depreciation is dependent upon three separate variables: i.

Establishing the depreciation base. Since an asset may be sold before its service value is completely consumed, the depreciation base is the cost of asset services that will be used by the firm and charged to expense during its service life; this usually is less than the original cost of the asset. The depreciation base of an asset is its acquisition cost plus removal costs at time of retirement and minus gross salvage value.

ii. Estimating the service life. This involves selecting the unit in which the service life of the asset is to be measured and then estimating the total number of units of service embodied in the asset. Although service life usually is measured in units of time, it may be more appropriate to use units of output or activity which usually are expressed in physical units such as tons, gallons, miles or machine-hours. In selecting the appropriate unit of service for each asset, consideration should be given to the factors that decrease the service life of an asset. These factors may be divided into two classes: (1) physical causes including casualties and (2) economic and functional causes. The physical causes are the physical deterioration and impaired utility of the asset that result (1) from wear and tear that is due to operating use and (2) from other forms of decay that are due to the action of the elements. Damage resulting from unusual events such as accidents, earthquakes, floods, hurricanes, and tornadoes also may reduce or end asset usefulness. An asset that is in good physical condition may lose its economic usefulness as a result of technological obsolescence and inadequacy (or economic obsolescence). Technological obsolescence results from innovations and improvements that make the existing plant obsolete. Inadequacy usually results from the effects of growth and change in the scale of a firm's operations that reduce or terminate the service life of assets. iii. Choosing the method of cost apportionment. The problem here is to determine the relative portion of services that has expired in each accounting period. This might be approached by estimating whether all units of service are equally valuable (and have an equal cost) or whether some service units have a higher value and cost than others. The two major variables to be considered in reaching the rational and systematic solution to this problem are: (1) whether the quantity of services withdrawn from the bundle will be equal or will vary during the periods of service life and (2) whether the value or cost of various units of service will be equal or will vary during the periods of service life.

129

There are a number of systematic depreciation methods that recognize these factors in varying degrees and could be used for the computer system; these may be classified as follows: i. On the basis of time-(1) A constant charge per period, i.e., the straight-line method. (2) A decreasing charge per period, i.e., a declining- balance or the sum-of-the years digits method. (3) An interest (increasing charge) method in which the depreciation charges are adjusted using the entity's average internal rate of return. ii. On an output measure basis-(1) A charge based upon a ratio of a constant cost to net revenue contribution; i.e., the cost allocation for each period would be a constant proportion of the net revenue contribution of the computer system. (2) A charge based upon the expected physical services from the computer system; i.e., the cost allocation would be in terms of hours, days or months of operation or some other measure of input or output related to the computer services.

Case 9-4 a.

A firm may wish to construct its own fixed assets rather than acquire them from outsiders to utilize idle facilities and/or personnel. In some cases fixed assets may be self-constructed to effect an expected cost savings. In other cases the requirements for the asset demand special knowledge, skills, and talents not readily available outside the firm. Also, the firm may want to keep the manufacturing process for a particular product as a trade secret.

Costs which should be capitalized for a self-constructed fixed asset include all direct and indirect material and labor costs identifiable with the construction. All direct overhead costs identifiable with the asset being constructed should also be capitalized. Examples of costs elements which should be capitalized during the construction period include charges for licenses, permits and fees, depreciation of equipment used in the construction, taxes, insurance, and similar charges related to the assets being constructed.

.i.

ii.

The increase in overhead caused by the self-construction of fixed assets should be capitalized. These costs would not have been incurred if the assets had not been constructed. This proposition holds regardless of whether or not the plant is operating at full capacity. It is improper to increase the cost of finished goods with costs which were not incurred in their manufacture and which would not have been incurred if fixed assets had not been produced. However, if the total construction costs on self-constructed fixed assets were substantially in excess of their business and economic usefulness, the excess cost should not be capitalized but should instead be recorded as a loss. It is clear that the capitalized costs of self-constructed assets should include a proportionate share of overhead on the same basis as that applied to goods manufactured for sale when the plant is operating at full capacity at the time the fixed asset in constructed. Under these circumstances costs of finished goods produced should not be increased for overhead for goods for which production was foregone. The activity replacing the production of goods for sale should be charged with the related overhead.

130

When idle plant capacity is used for the construction of a fixed asset, opinion varies as to the propriety of capitalizing a share of general factory overhead allocated on the same basis as that applied to goods manufactured for sale. The arguments to allocate overhead maintain that constructed fixed assets should be accorded the same treatment as inventory, new products, or joint products. It is maintained that this procedure is necessary, or special favors or exemptions from undercosting of fixed assets will cause a consequent overcosting of inventory assets. Those arguing against allocating overhead to fixed assets where the assets are constructed when idle capacity exists maintain that since normal production will not be affected or overhead increased, capitalization will result in increased reported income for the period resulting from construction rather than production of goods for sale. It is also sometimes maintained that the full cost of the constructed asset should not include overhead that would be incurred in the absence of such construction. d.

The $90,000 cost by which initial machines exceeded the cost of the subsequent machines should be capitalized. Without question there are substantial future benefits expected from the use of this machine. Because future periods will benefit from the extra outlays required to develop the initial machine, all development costs should be capitalized and subsequently associated with the related revenue produced by the sale of products manufactured. If, however, it can be determined that the excess cost of producing the first machine was the result of inefficiencies or failures which did not contribute to the machine's successful development, these costs should be recognized as an extraordinary loss. Subsequent periods should not be burdened with charges arising from costs which are not expected to yield future benefits. Capitalizing the excess costs as a cost of the initial machine can be justified under the general rules of asset valuation. That is, an asset acquired should be charged with all costs incurred in obtaining the asset and placing it in productive use. A case could also be made for prorating the excess cost of developing the first machine equally to all four machines on the grounds that these costs were necessary in order to obtain the four machines. In this case, the acquisition of the four machines is analogous to a "basket" purchase where proration is acceptable. Although less supportable, another alternative treatment of the excess costs of developing the initial machine is to treat the costs as research and development. Under current GAAP costs of research and development are expensed as incurred.

Case 9-5 a.

The fair market value of the acquired site, as evidenced by the contract price, is $60,000. It is the amount that represents the actual bargained price of the land in a cash transaction. To charge any portion of the option costs to the land account is to disregard the bargained price of the acquired site and, further, implies that the land is more valuable because of the options. The purchase of the options enabled the client to delay his/her selection of a site until the advantages and disadvantages of each were carefully weighted. The benefits to be derived from the net advantage of the selected site over the rejected sites will accrue to the operations of the contemplated plant facility. The cost of the options should therefore be separately capitalized and allocated to the periods benefited.

131

It may also be argued that the cost of the options represents management's failure to plan for the acquisition of a site. Such a contention leads to the conclusion that the cost of the option is a loss and should be expensed immediately, and it supports the recording of the cost of the acquired site at $60.000. b.

The actual cost of the selected site is the sum of the contract price plus the cost of the option which was exercised to purchase the land. All costs incurred to secure title to the land are properly includable as part of its cost. However, to capitalize the cost of the options that were allowed to lapse would be inappropriate. They have no bearing on the acquisition of effective title to the selected site and should be treated as a loss.

The options were purchased with full knowledge that, after the relative advantages of the three locations were investigated, only one of the options would be exercised. Because the intent was to purchase only one of the three sites, the options should be viewed as an integrated plan for acquiring the site which was ultimately selected. Thus, the cost of all three options should be capitalized as a part of the cost of acquiring the selected site.

Case 9-6 a.

Relative to plant assets, a cost incurred or an expenditure made, that is assumed to benefit only the current accounting period is called a revenue expenditure and is charged to expense in the period believed to benefit. A capital expenditure is similarly a cost incurred or an expenditure made but is expected to yield benefits either in all future accounting periods (acquisition of land) or in a limited number of accounting periods. Capital expenditures (if material in amount) are capitalized, that is, recorded as assets, and, if related to assets of limited life, amortized over the periods believed to benefit. The distinction between capital and revenue expenditures is of significance because it involves the timing of the recognition of expense and, consequently, the determination of periodic earnings. It also affects the amounts reported as assets whose costs generally have to be recouped from future periods' revenues. If a revenue expenditure is improperly capitalized, current earnings are overstated, assets are overstated, and future earnings are understated for all the periods to which the improperly capitalized cost is amortized. If the cost is not amortized, future earnings will not be affected but assets and retained earnings will continue to be overstated for as long as the cost remains on the books. If a nonamortizable capital expenditure is improperly expensed, current earnings are understated and assets and retained earnings are understated for all periods for which unamortized cost should have remained in the accounting records. If an amortizable capital expenditure is improperly expensed, current earnings are understated, assets and retained earnings are understated, and future earnings are overstated for all periods to which the cost should have been amortized.

Depreciation is the accounting process of allocating an asset's historical cost (recorded amount) to the accounting periods benefited by the use of the asset. It is a process of cost allocation, not valuation. Depreciation is not intended to provide funds for an asset's replacement; it is merely an application of the matching concept.

The factors relevant in determining the annual depreciation for a depreciable asset are the initial recorded amount (cost), estimated salvage value, estimated useful life, and depreciation method. 132

Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost assignments in other cases --"basket purchases" and the selection of an implicit interest rate in asset acquisition under deferred-payment plans--may be quite subjective involving considerable judgement. The salvage value is an estimate of an potentially realizable when the asset is retired from service. It is initially a judgment factor and is affected by the length of its useful life to the enterprise. The useful life is also a judgment factor. It involves selecting the "unit" of measure of service life and estimating the number of such units embodied in the asset. Such units may be measured in terms of time periods or in terms of activity (for example, years or machine hours). When selecting the life, one should select the lower (shorter) of the physical life or the economic life to this user. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy. Selecting the depreciation method is generally a judgment decision; but, a method may be inherent in the definition adopted for the units of service life, as discussed earlier. For example, if such units are machine hours, the method is a function of the number of machine hours used during each period. A method should be selected that will best measure the portion of services expiring each period. Once a method is selected, it may be objectively applied by using a predetermined, objectively derived formula. d.

Because revenue usually represents an inflow of funds, and expense usually represents an outflow of funds, net earnings represent a net inflow of funds. However, the revenues and expenses reported in the income statements are accrual-based, not cash-based measures. Hence, net income must be adjusted to measure the net cash flows from operations. Depreciation reduces reported net earnings but does not involve an outflow of cash. Therefore, it is added back to reported net earnings to calculate cash provided by operations. On a statement of cashflows, depreciation should be clearly shown as an adjustment to net earnings not requiring a use of cash rather than be shown as a source of cash. Depreciation is not a direct source of cash. It can be considered an indirect source only through income tax savings.

Case 9-7 The following costs, if applicable, should be capitalized as a cost of land: a.

(a) Negotiated purchase price (b) Brokers' commission (c) Legal fees (d) Title fees (e) Recording fee (f) Escrow fees (g) Surveying fees (h) Existing unpaid taxes, interest, or liens assumed by the buyer (i) Clearing, grading, landscaping and subdividing (j) Cost of removing old building (less salvage) (k) Special assessments such as lighting or sewers if they are permanent in nature. 133

A plant asset acquire on a deferred-payment plan should be recorded at an equivalent cash price excluding interest. If interest is not stated in the sales contract, an imputed interest should be determined. The asset should then be recorded at its present value, which is computed by discounting the payments at the stated or imputed interest rate. The interest portion (stated or imputed) of the contract price should be charged to interest expense over the life of the contract.

In general, plant assets should be recorded at the fair value of the consideration given or the fair value of the asset received, whichever is more clearly evident. Specifically, under the criteria contained at FASB ASC 845, when exchanging an old machine and paying cash for a new machine, the new machine should be recorded at the amount of monetary consideration (cash paid plus the undepreciated cost of the nonmonetary asset (old machine) surrendered if there is no indicated loss. No indicated gain should be recognized by the party paying monetary consideration. If cash is received, gains are not recognized; however, a loss should be recognized if the fair value of the asset exchanged is less than its book value (i.e., an impairment is evident). The resulting amount initially recorded for the acquired asset is equal to the book value of the exchanged asset (adjusted to its fair value, when there is an apparent impairment) plus or minus any cash (boot) paid or received.

Case 9-8 a.

Expenditures should be capitalized when they benefit future periods. The cost to acquire the land should be capitalized and classified as land, a nondepreciable asset. Since tearing down the small factory is readying the land for its intended use, its cost is part of the cost of the land and should be capitalized and classified as land. As a result, this cost will not be depreciated as it would if. it were classified with the capitalizable cost of the building. Since rock blasting and removal is required for the specific purpose of erecting the building, its cost is part of the cost of the building and should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the estimated useful life of the building. The road is a land improvement, and its cost should be capitalized and classified separately as a land improvement. This cost should be depreciated over its estimated useful life. The added four stories is an addition, and its cost should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the remaining life of the original office building because that life is shorter than the estimated life of the addition.

The gain should be recognized on the sale of the land and building because income is realized whenever the earning process has been completed and the sale has taken place. The net book value at the date of sale would be composed of the capitalized cost of the land, the land improvement, and the building, as determined above, less the accumulated depreciation on the land improvement and the building. The excess of the proceeds received from the sale over the net book value at the date of the sale would be accounted for as a gain and included in income from continuing operations in the income statement.

Case 9-9 134

The expenditures that should be capitalized when equipment is acquired for cash should include the invoice price of the equipment (net of discounts) plus all incidental outlays relating to its purchase or preparation for use, such as insurance during transit, freight, duties, ownership search, ownership registration, installation, and breaking-in costs. Any available discounts, whether taken or not, should be deducted from the capitalizable cost of the equipment.

. i. When the market value of the equipment is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased with bonds having an established market price should be the market value of the bonds. ii. When the market value of the equipment is not determinable by reference to a similar cash purchase, and the common stock used in the exchange does not have an established market price, the capitalizable cost of equipment should be the equipment's estimated fair value if that is more clearly evident than the fair value of the common stock. Independent appraisals may be used to determine the fair values of the assets involved. iii. When the market value of equipment acquired is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased by exchanging similar equipment having a determinable market value should be the lower of the recorded amount of the equipment relinquished or the market value of the equipment exchanged.

The factors that determine whether expenditures relating to property, plant, and equipment already in use should be capitalized are as follows: . Expenditures are relatively large in amount. . They are nonrecurring in nature. . They extend the useful life of the property, plant, and equipment. . They increase the usefulness of the property, plant, and equipment.

The net book value at the date of the sale (cost of the property, plant, and equipment less the accumulated depreciation) should be removed from the accounts. The excess of cash from the sale over the net book value removed is accounted for as a gain on the sale and reported on the income statement, while the excess of net book value removed over cash from the sale is accounted for as a loss on the sale and reported on the income statement.

Case 9-10 a.

Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It includes the purchase price and all cost necessary to acquire the asset and get it ready for its intended use. Use of historical cost presents the economic facts as they actually occurred. Thus, it is relevant and reliable. It is relevant because accountants are stewards to owners. The stewardship role implies that accountants must report how moneys invested are spent. This information is disclosed by historical prices paid to acquire assets. Historical cost is reliable because it is objective and verifiable. Historical exchange prices are objectively determinable and verifiable because they are based on evidence that an exchange has taken place and amounts are typically supported by a paper trail, e.g., invoices. Hence, they these measurements represent what they purport to represent and as such are represenationally faithful and neutral. An asset is defined as an economic resource that has future benefit to the entity and results from prior transactions and events. The prior transaction resulting in its existence is the exchange that 135

occurred when the asset was acquired. Those moneys were invested in the asset to provide economic benefit to the company. So long as the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report to investors, creditors, and other users. b.

Under the present accounting model, the cost of cleanup would be considered cost of land. The cost of land includes its acquisition price and all costs incurred to get it ready for its intended use. In this example the intended use to have a building built on it. Since, the cleanup is necessary before building can begin, the cost of cleanup is a cost to get the land ready for its intended use and should be capitalized as land. Under this scenario the presumption is that the cleanup cost was necessary to acquire the asset, hence it provides future benefit. The cleanup itself provides value because without it the land is not usable as a building site, and would presumable be worth less. Hence, this expenditure fits the definition of an asset.

Case 9-11 a.

The stewardship role of accounting implies that accountants should report on how moneys were invested in assets and the performance resulting from making those investments. This notion is consistent with reporting assets at historical cost. Long-term assets provide benefits for a number of time periods. Investments are made in fixed assets so that over the long-run revenues will be generated. Fixed asset investments thus generate revenues over multiple accounting periods. The matching principle implies that these revenues should be matched with the cost of generating them. Because an element of this cost is the cost of long-term fixed assets these costs should be matched with the revenues they generate, implying that the cost should be allocated to those periods in which the revenues (benefits) are expected to occur.

Accountants believe that cost allocation provides relevant information because it attempts to match cost with revenue and thus provides measures of performance. On the other hand, all allocation schemes are by their very nature arbitrary. As such, they are not objective. Also, one could argue that cash flow is all that matters with regard to fixed assets. In other words, purchasing a fixed asset is an investing activity, a cash outflows. It is not an operating activity. It provides physical assets to generate revenue, but it is a sunk cost and does not recur on an annual basis.

If the purpose of the balance sheet is to disclose resources and claims to resources, historical cost once the asset has been purchased may no longer be relevant. Historical cost does not provide a measure of the current value of the asset in use. Each period the company in effect makes a conscious decision to keep the asset. These decisions imply that the company is, in effect, reinvesting in the asset. Reinvestment decisions are made based on replacement cost. Hence, replacement cost would provide relevant measures of fixed assets.

Yes, a current value approach to the valuation of fixed assets would be consistent with the physical capital maintenance concept. The concept of physical capital maintenance is concerned with maintaining productive capacity, the operating assets of the entity. Assets must eventually be replaced in order to maintain the current level of productive capacity. Hence, measurement of assets at their replacement cost, a current cost measure, is consistent with the physical capital maintenance concept.

The major problems associated with use of replacement cost relate to determining the amount of replacement cost. Once purchased, the replacement cost of fixed assets may be difficult if not practically impossible to determine. Replacement cost is the cost to replace the assets with 136

similar assets in similar condition. But, there may be no ready market for the assets. In these cases it may be necessary to obtain appraisal values in order to approximate replacement cost. In some cases specific price indexes may be used, but these measures provide reasonably approximations only when the price of the asset being measured moves in the same way as the movement of the price index. Moreover, relevance of replacement cost may be questionable. It can be argued that entry values are relevant only when purchase is contemplated. For owned assets replacement cost may be irrelevant because these assets will either be used or sold. Hence, a better measure of current value may be net realizable value. FASB ASC 9-1 Depreciation FASB ASC 360-10-35 Found by searching “depreciation and property, plant and equipment” or by accessing the Assets link and selecting Property, plant and equipment, overall. Specifically, the definition of depreciation is contained in FASB ASC 350-10-35-4. The pronouncements dealing with depreciation can be found by accessing the Printer Friendly with sources link. . FASB ASC 9-2 Asset Impairment A search of “asset impairments” resulted in over 130 entries. The EITF issues can be found by searching asset impairment and EITF. FASB ASC 9-3 Asset Retirement Obligations The discussion of asset retirement obligations is contained at FASB ASC 410 Found by searching “asset retirement obligations” or through the cross reference section using the original pronouncement number FAS 143. The EITF issues can be found by accessing the Printer Friendly with sources link at topic 410.

FASB ASC 9-4 Disclosure of Depreciation Found by accessing the Assets link, selecting Property, plant and equipment and selecting disclosure. Topic 360-10-50 FASB ASC 9-5 Overhaul Costs in the Airline Industry Select the industry link and then choose airlines. Select Property and Equipment and then Initial Measurement. Topic 908-360 FASB ASC 9-6 Accounting for the Mining Extractive Industry Select the industry link and then choose extractive industry-mining. Topic 930-330 137

FASB ASC 9-7 Franchise Prematurity Period Select the industry link and then choose franchises. Topic 952. Debate 9-1 Team 1 Argue for the capitalization of interest The FASB considers interest incurred during construction of the asset as an element of historical cost. Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It includes the purchase price and all cost necessary to acquire the asset and get it ready for its intended use. Use of historical cost presents the economic facts as they actually occurred. Thus, it is relevant and reliable. It is relevant because accountants are stewards to owners. The stewardship role implies that accountants must report how moneys invested are spent. This information is disclosed by historical prices paid to acquire assets. Historical cost is reliable because it is objective and verifiable. Historical exchange prices are objectively determinable and verifiable because they are based on evidence that an exchange has taken place and amounts are typically supported by a paper trail, e.g., invoices. Hence, they these measurements represent what they purport to represent and as such are represenationally faithful and neutral. An asset is defined as an economic resource that has future benefit to the entity and results from prior transactions and events. The prior transaction resulting in its existence is the exchange that occurred when the asset was acquired. Those moneys were invested in the asset to provide economic benefit to the company. So long as the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report to investors, creditors, and other users. According to SFAS No. 34, (See FASB ASC 835-20) interest during construction is a cost of getting the asset ready for its intended use. Moneys were spent to construct the asset. Debt existed so that the moneys could be available to spend on construction costs. If the moneys had not been spent on constructing the asset, the moneys could have been used to extinguish the debt. Hence, the interest on the debt was avoidable. Because the interest was avoidable, its incurrence during the construction period implies that it was directly attributable to the construction itself. As such, it is properly classified as a construction cost, i.e., costs attach. It is a cost of getting the asset ready for its intended use and should be capitalized along with other construction costs. Team 2 Argue against the capitalization of interest Interest is the cost of debt, not the cost of an asset. Interest is a function of time. As such it is a period cost, i.e., an expense of the accounting period. Debt is incurred to acquire assets which will be employed to generate future cash inflows, or revenues. The assets generate the revenue, not the debt. Hence, the assets constitute the physical plant, the operating assets of the business enterprise. When operating assets are used up their cost expiration is considered an expense of operations. Alternatively, because debt is not a part of the physical plant, the cost of debt (interest) is not considered an operating expense. Rather, it is a nonoperating cost, or expense, of doing business. 138

According to SFAC No. 6, expenses are outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. Debt provides moneys to acquire assets. The assets are used to deliver or produce goods, etc. Interest is incurred to provide debt. Thus, indirectly, the interest is an outflow of assets, incurred in the process of delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. It is incurred during the accounting period in which those activities take place and is a cost, or expense, of the period. It should not be capitalized as a part of the historical cost of the constructed asset. Finance theory is consistent with the argument that interest incurred during construction should not be capitalized. Modern capital structure theory views creditors as capital providers. The corporation determines how much debt versus common stock it wants in its capital structure. In other words, moneys can be supplied to acquire assets with debt or by issuing common stock. According to finance theory, the interest on the debt, like dividends to common stockholders, is a payment to capital providers, a return on their investment in the business. As such it represents a distribution of income, not a cost incurred to acquire an asset. Under this theory, interest would not only not be a part of the historical cost of the asset, it would not even be considered an expense. Debate 9-2 Donated Assets Team 1. Donated assets should not be reported in a company’s balance sheet. Firstly, a donation is a non-reciprocal transfer. The company did not give up anything to acquire donated assets. Therefore, there is no cost. According to the historical cost principle, the cost of an asset includes all costs that were necessary to acquire an asset and get it ready for its intended use. Since, nothing was expended to acquire the asset or get it ready for its intended use, the historical cost principle would be consistent with reporting no value on the company’s balance sheet. Secondly, non-reporting of donated assets is consistent with financial capital maintenance, noted by the FASB in the Conceptual Framework as appropriate for financial reporting. Accordingly, financial accounting would report what was done with the dollars invested by owners. Since no investor dollars were spent to acquire a donated asset, there is nothing to report. Finally, not reporting a value for donated assets is objective. Reporting fair value would require subjective estimates that may not be unbiased, or if unbiased may not reflect the fair value of the donated assets. If so, the reported values may not be relevant to users. Team 2. Donated assets should be reported in a company’s balance sheet at fair value. They represent an inflow of assets to the company from non-owner sources. They meet the definition of assets. They are probable future benefits owned or controlled by the company that resulted from a prior transaction or event (the donation). Thus, representational faithfulness would require that they be reported in the balance sheet until used up as an expense.

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Reporting fair value of donated assets would provide relevant information to users regarding the financial position of the company. The company would not have a hidden asset and the principle of full disclosure would be met. WWW Case 9-12 a.

Under current GAAP an asset is considered impaired when the total expected future cash inflows are less than the book value (carrying value) of the asset. That is, the carrying value of the asset if not recoverable.

Under current GAAP, an impairment loss is equal to the difference between the book value of the asset and its fair market value.

Less conservative. The recoverable amount is equal to the gross (total) expected cash flows. This amount would be greater than fair value. Fair value is typically presumed to be the present value of expected future cash flows. Hence, the loss measured using the recoverable amount would be smaller, and income would be higher (not conservative). Conservatism implies that when choosing between two alternatives, the one resulting in the lower net income would be selected.

Current GAAP measurement of the loss would be more consistent with the economic concept of income. The economic concept views income as the change in wealth (the value of the company) from one period to the next, excluding investments by and distributions to owners. Fair value is a current value measure of wealth, gross future cash flows would not measure current value.

Case 9-13 Three approaches have been suggested to account for actual interest incurred in financing the construction or acquisition of property, plant, and equipment. 1. Capitalize no interest during construction. Under this approach interest is considered a cost of financing and not a cost of construction. It is contended that if the company had used stock financing rather than debt financing, this expense would not have developed. The major arguments against this approach are that an implicit interest cost is associated with the use of cash regardless of the source. 2. Capitalize the actual interest costs. This approach relies on the historical cost concept that only actual transactions are recorded. It is argued that interest incurred is as much a cost of acquiring the asset as the cost of the materials, labor, and other resources used. As a result, a company that uses debt financing will have an asset of higher cost than an enterprise that uses stock financing. The results achieved by this approach are held to be unsatisfactory by some because the cost of an asset should be the same whether cash, debt financing, or stock financing is employed. 3. Charge construction with all costs of funds employed, whether identifiable or not. This approach is an economic cost approach that maintains that one part of the cost of construction is the cost of financing whether by debt, cash, or stock financing. An asset should be charged with all costs necessary to get it ready for its intended use. Interest, whether actual or imputed, is a cost of building, just as labor, materials, and overhead are 140

costs. A major criticism of this approach is that imputation of a cost of equity capital is subjective and outside the framework of a historical cost system. Current GAAP requires that the lower of actual or avoidable interest cost be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition or location necessary for its intended use. Interest costs would be capitalized (provided interest costs are being incurred) starting with the first expenditure related to the asset and would continue until the asset is substantially completed and ready for its intended use. Capitalization should occur only if the benefits exceed the costs. Case 9-14 a.

The issues discussed in IAS No. 16 are the timing of recognition of assets, the determination of their carrying amounts, and the associated depreciation charges to be recognized. The revised IAS No. 16 did not change the fundamental approach to accounting for property, plant and equipment. The Board’s purpose in revising the standard was to provide additional guidance on selected matters.

IAS No. 16 indicates that items of property, plant, and equipment should be recognized as assets when it is probable that the future economic benefit associated with these assets will flow to the enterprise and that their cost can be reliably measured.

Case 9-15 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution.

Financial Analysis Case Answers will vary depending on company selected

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________________________________________________ CHAPTER 10 ________________________________________________ Case 10-1 a.

Managerial intent plays a significant role in the accounting treatment of investments in equity securities that have readily determinable fair values. When the owner of the securities is unable to exercise significant influence, as in the case of Quip, the accounting treatment is proscribed by FASB ASC 320. If managerial intent is to trade securities to realize short-term gains, they are classified as trading securities. If not they will be classified as available-for-sale securities. For both classifications, the securities are reported as assets in the balance at their fair market value. Unrealized holding gains and losses on securities classified as trading securities are reported on the income statement as current period income. Unrealized holding gains and losses on securities classified as available-for sale securities are reported as a component of stockholders’ equity as other comprehensive income on the balance sheet and in the statement of stockholders’ equity.

The reclassification would result in the recognition of a cumulative unrealized holding gain of $4,000 ($27,000 - 23,000) on the income statement.

If management actually intends to sell the stock in 2015 no ethical issue is involved. However, if the stock was purchased for its dividend return, and Maxey does not actually intend to sell it in 2015, it would be unethical to reclassify the stock in order to report the unrealized gain as income in 2014.

Allowing changes in classifications from available-for -sale to trading can result in income manipulation. It is unlikely that a change in classification would be reported during a period in which the value of the security declined, as was the case for Maxey in 2013. The actual effect on income for the two years was a loss of $1,400 in 2013 and a gain of $5,400 in 2014. However, the reclassification in 2014 hides the 2013 loss. As indicated in part c. above, changes in classifications allow the possibility of income manipulation by management.

Case 10-2 a.

For both the current and noncurrent marketable equity securities portfolios, the difference between the selling price and the cost is a realizable gain or loss that should be included in the net income for the year because a gain or loss should be recognized at the culmination of the earning process, namely, in the year when realization (sale) takes place.

Victoria should account for both the current and noncurrent marketable equity securities portfolios at the lower of its aggregate cost or market value, determined at the balance sheet date. Because of the uncertainty of recovery, it is conservative to carry both the current and noncurrent marketable equity securities portfolios at market value when market value is below cost. The amount by which the aggregate cost of the portfolio exceeds the market value should be accounted for as a valuation allowance for both the current and noncurrent marketable equity securities portfolios. 142

For the current marketable equity securities portfolio, the change in the valuation allowance for the year should be included as a reduction in net income for the year because the portfolio is a current asset and the probability of realization of the loss is sufficiently high to justify inclusion in net income. For the noncurrent marketable equity securities portfolio, the accumulated change in the valuation allowance should be included in the equity section of the balance sheet and shown separately as other comprehensive income. In the case of the noncurrent marketable equity securities, it is argued that a decline in market value viewed as temporary should not be reflected in net income because the probability of realization is small. c.

Victoria should account for the disposition prior to their maturity of the long-term bonds called by their issuer by recognizing the difference between the call price and the net carrying value of the investment as a gain or loss that should be included in net income for the year because the earning process has been completed and realization has taken place.

Victoria should report the purchase price of the additional similar bonds as investment in longterm bonds-a noncurrent asset-and the two months' accrued interest as interest receivable-a current asset. The amount paid by Victoria for the two months' interest accrued between the last interest payment and the date of the purchase should not be included in the investment in longterm bonds because Victoria will receive this amount back when the next interest payment is made by the issuer of the bonds. As a result, interest income will be appropriately recognized for the period from the date of the purchase to the next interest payment date.

Case 10-3 a.

Dynamic Company should follow the equity method of accounting for its investment in Cart Company because Dynamic Company is presumed, because of the size of its investment, to be able to exercise significant influence over the operating and financial policies of Cart Company. In 2014, Dynamic Company should report its interest in Cart Company's outstanding capital stock as a long-term investment. Following the equity method of accounting, Dynamic Company should record the cash purchase of forty percent of Cart Company at cost, which is the amount paid. Forty percent of Cart Company's total net income from July 1, 2014 to December 31, 2014, should be added to the carrying amount of the investment in Dynamic Company's balance sheet and shown as revenue in its income statement to recognize Dynamic Company's share of the net income of Cart Company after the date of acquisition. This amount should reflect adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses, and to amortize, if appropriate, any difference between Dynamic Company's cost and the underlying equity in net assets of Cart Company on July 1, 2014. The cash dividends paid by Cart Company to Dynamic Company should reduce the carrying amount of the investment in Dynamic Company's balance sheet and have no effect on Dynamic Company's income statement. As a result of following the equity method of accounting, Dynamic Company would generally need to report deferred income taxes in its balance sheet and income statement.

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If Dynamic elects to report the investment at fair value, it is reported in the balance sheet at fair value. Fair value is to be measured using exit prices on the balance sheet date. SFAS No. 159 defines fair value as the price that reporting entity would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants. All unrealized holding gains and losses are to be reported in earnings. Dynamic must separately disclose assets and liabilities pursuant to electing fair value in a manner that clearly separates them from the carrying values of other assets and liabilities, either parenthetically by a single line that includes both or on separate lines in the balance sheet. Moreover, if the fair value option is elected for available-for-sale and/or held-to-maturity securities when SFAS No. 159 is adopted, they are to be reported as trading securities. The cumulative effect of the gains and losses for these securities are to be reported as an adjustment to retained earnings.

Case 10-4 a.

Research, as defined in Statement of Financial Accounting Standards No.2, is "planned research or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service...or a new process or technique...or in bringing about a significant improvement to an existing product or process." Development, as defined in Statement of Financial Accounting Standards No. 2, is "the translation of research findings or other knowledge into a plan or design for a new product or process for a significant improvement to an existing product or process whether intended for sale or use."

The current accounting and reporting practices for research and development costs were promulgated by the Financial Accounting Standards Board (FASB) in order to reduce the number of alternatives that previously existed and to provide useful financial information about research and development costs. The FASB considered four alternative methods of accounting: (1) charge all costs to expense when incurred; (2) capitalize all costs when incurred: (3) selective capitalization; and (4) accumulate all costs in a special category until the existence of future benefits can be determined. The FASB concluded that all research and development costs should be charged to expense as incurred. (Statement of Financial Accounting Standards No. 2 does not apply to activities that are unique to enterprises in the extractive industries, and accounting for the costs of research and development activities conducted for other under a contractual agreement is a part of accounting for contracts in general and is beyond the scope of that statement.) In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (1) associating cause and effect; (2) systematic and rational allocation, and (3) immediate recognition. The FASB found little or no evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits. The high degree of uncertainty surrounding future benefits, if any, of individual research and development projects makes it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods. In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the "immediate recognition" principle of expense recognition should apply.

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The high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category. c.

In accordance with Statement No. 2 of the Financial Accounting Standards Board, the following costs attributable only to research and development should be expensed as incurred: a. b. c. d.

Design and engineering studies. Prototype and manufacturing costs. Administrative costs related solely to research and development. The cost of equipment produced solely for development of the product ($200,000).

The remaining $300,000 of equipment should be capitalized and shown on the statement of financial position at cost. The depreciation expense resulting from the current year is a part of research and development expense for the year. The market research direct costs and related administrative expenses are not research and development costs. These costs are treated as period costs and are shown as expense items in the current earnings statement. Case 10-5 a.

FASB ASC 320 defines trading securities as securities that are bought and held principally for the purpose of selling them in the near term. Trading generally reflects active and frequent buying and selling, and trading securities are generally acquired to generate profits on short-term differences in market prices. Trading securities include debt securities and equity securities with readily determinable fair market values, and which the owner does not have significant influence or control over the investee. Like trading securities, available-for-sale securities also include debt securities and equity securities with readily determinable fair market values and for which the owner does not have significant influence or control over the investee. However, available-for-sale securities are not bought and help principally for the purpose of selling them in the near term. Investments in securities not classified as trading, should be considered available for sale unless in the case of debt securities the purchaser intends to hold them to maturity. Hence, these securities include investments in securities that are to be held for longer-term price appreciation and other purposes.

Trading securities are classified in the balance sheet as current assets. This is because they are purchased to be held only for a short period of time. Management intent regarding the purpose of the buying and holding the securities must be ascertained in order to determine whether to classify them as trading or available-for-sale. Available-for-sale securities may be classified in the balance sheet as either current or long-term. In determining the specific classification, we are to refer to the provisions FASB ASC 210-1020.Thisguidanceindicates that an asset is considered current if it will be consumed or converted into cash within the normal operating cycle of the business or one year whichever is longer.

Unrealized gains and losses are recognized in the income statement for trading securities and as an adjustment to stockholders’ equity (now a component of comprehensive income) for 145

securities that are available-for-sale. That is, holding gains and losses are given the same treatment as realized gains and losses when the security is considered a trading security. d.

This question has no real answer but is meant to allow students to ponder the issue. Presumably companies have short term securities to speculate in the near term. Long-term securities are held because they provide a cash return and for price appreciation over the long-term. Also, longterm securities may be held in order for the investor to influence or even control investee activities.

If the fair value option is elected for available-for-sale and/or held-to-maturity securities when SFAS No. 159(See FASB ASC 825-10) is adopted, they are to be reported as trading securities. The cumulative effect of the gains and losses for these securities are to be reported as an adjustment to retained earnings.

Case 10-6 Situation 1

When a stock experiences a decline in value that is considered other than temporary, its value is considered impaired. This stock is in a noncurrent portfolio, hence, it is not a trading security. If the security is considered available-for-sale, the loss should be recognized in the income statement for the difference between cost and fair value and the new asset basis would become fair value at the date the loss is recognized.

Situation 2

The trading securities should be considered current assets. The assets should be reported at fair value, and the $2,000 decline in value should be recognized in the income statement. The remainder of the portfolio should be considered current or noncurrent depending on management’s intention. In this event, these securities would be considered available-for-sale. They should be reported in the balance sheet at fair value, and the $5,000 unrealized gain would be reported in stockholders’ equity as an element of comprehensive income.

Situation 3

When a marketable security is reclassified from a trading security to available-for-sale, it will appear in the balance sheet as a current asset, measured at fair value. The accumulated unrealized gain/loss to the date of reclassification would be recognized in net income - i.e., it would be removed from equity. This would mean that current period comprehensive income would include a gain or loss from the beginning of the period to the date of the reclassification and the amount of accumulated equity adjustment(accumulated other comprehensive income) would be eliminated.

Situation 4

This security would be presented in the balance sheet at fair value. The change in fair value from the beginning of the period to the end would be reflected in other comprehensive income. The amount would be equivalent to the accumulated other comprehensive income reported in stockholders’ equity.

Case 10-7 a.

IAS No. 39 allows long-term investments in equity securities to be reported at cost, market value, or lower-of-cost-or market. Revaluations to market which result in gains are treated as equity adjustments (like U.S. GAAP), but revaluations that result in losses in excess of accumulated prior gains are recognized in the income statement (unlike U.S. GAAP). Other 146

than temporary declines are treated in a manner similar to U.S. GAAP. U.S. GAAP does not allow these securities to be reported at cost or at lower-of-cost-or-market. b.

Because IAS No. 39 recognizes holding losses for securities that are revalued in the income statement and SFAS No. 115 (See FASB ASC 320) does not, IAS No. 39 would provide more conservative measures of income. Asset measures would be the same.

ii. U.S. GAAP is consistent in treatment from period to period and among investments regardless of whether gains or losses occur. IAS No. 39 is not. Hence, SFAS No. 115 (See FASB ASC 320) would provide for better comparability over time. However, IAS No. 39 allows for alternative treatments among companies - cost, market values, or lower-of-cost-or-market. Hence, companies using different approaches would not be comparable. Under SFAS No. 115 (See FASB ASC 320), all companies investing in available-for-sale-securities would account for them in the same ways. Thus, U.S. GAAP would provide greater comparability among reporting entities. iii. U.S. GAAP requires reporting of fair value in the balance sheet. Since these are marketable securities, fair value measures what can be realized from sale of the assets and thus would be relevant to investors. By allowing three different approaches, it is difficult to argue that international accounting is always relevant. Available-for-sale securities are invested in for their price appreciation and or dividend income over the long-run. Cost of these investments would not be relevant to the decision to hold or sell, hence, it would not provide a relevant measure of the performance of management investment strategies. A similar argument could be made for the use of lower-of-cost-or market. iv. U.S. GAAP would be more neutral than IASC GAAP. All companies would be required to report investments in available-for-sale securities in the same way and measures of fair value would be unbiased because they are readily determinable in the market. In allowing alternative treatments, IASC No. 39, lets management select the accounting treatment they want thereby allowing the potential for management to bias reported financial information. v. US. GAAP would report the fair value of the investments in available-for-sale securities. Again, fair value is relevant to the decision to hold or sell. Hence, this measurement representation would faithfully represent the assets reported because it would measure the service potential of the assets at the balance sheet date. It follows, that if one approach is representationally faithful, others may fall short of providing this quality. Hence, IAS No. 39, would not always result in providing information that is representionally faithful. vi. Measuring the assets at fair value provides not only the exit value, but also provides the cost it would take to replace these assets. Hence, the asset values under SFAS No. 115, would be consistent with the physical capital maintenance concept. Also, holding gains are losses are not recognized in net income, which is also consistent with the physical capital maintenance concept. IASC No. 39 allows measures other than fair value. These alternative measures are not consistent with physical capital maintenance. Also excess losses are recognized in the income statement for those securities which are revalued. This practice is not consistent with the concept of physical capital maintenance. 147

Case 10-8 a.

Yes. Goodwill is considered to result from the ability of an enterprise to generate excess returns - returns greater than would be expected for investments in similar enterprises. This ability can be the result of management efficiency, market share, a better, more competent sales force, etc. Kallus is an industry leader and does generate profits in excess of others in similar lines of business.

Yes. Goodwill is an asset. Assets are defined in SFAC No. 6 as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The ability to generate excess profits has value. Excess profits are without question economic benefits. These benefits are obtained by the company which has goodwill. It can be argued that they result from prior transactions or events because the increased profits occur now and are expected to recur in the future to prior activities of management to increase market share, etc. Others argue that goodwill meets the definition of an asset only when an exchange transaction takes place, such as the purchase of a business.

The theoretical valuation of goodwill involves capitalizing expected excess earnings. The procedure would be as follows. First, determine what prior earnings have been. Eliminate nonrecurring items. Determine what the company typically earns (average earnings). Compute what earnings would be if the company earned what others in the industry earn. The difference between the company’s average earnings and that of the typical company are considered excess earnings. Take the present value of the expected excess earnings (divide excess earnings by the capitalization rate). The present value is the estimated value of goodwill.

No. Under current GAAP goodwill is not reported unless it is acquired in an arm’s length transaction, e.g., a purchase. First, financial accounting under the traditional accounting model is transaction based. Hence, goodwill should not be recorded unless a transaction occurs. Second, the theoretical value of goodwill is too subjective and would not provide an objective, verifiable balance sheet measure.

FASB ASC 10-1 Debt and Equity Investments 1. 2.

Information on accounting for debt and equity securities is found at FASB ASC 320-10 and can be found by accessing assets and then investments, and finally debt and equity investments.” To find EITF pronouncements, use the Printer friendly with Sources function

FASB ASC 10-2 Research and Development Research and development implementation issues can be found by searching research and development implementation. Topic 730.To find EITF pronouncements, use the Printer friendly with Sources function FASB ASC 10-3 Best-Efforts-Basis, Research-and-Development-Cost-Sharing Arrangements Search Industries-contractors-federal government-research and development Topic 912-730-25 148

FASB ASC 10-4 Direct-Response Advertising Search Direct-Response Advertising Topic 340-20

FASB ASC 10-5 Accumulated Losses on Equity Method Investments Link Assets-Investments-Equity method and joint ventures 323-10-35-20 through 22 FASB ASC 10-6 Intangible Costs Search cable industry Topic 922 1. Found under 922-350 2. Found under 922-350-25-1 3. Found under 922-350-25-3 4. Found under 922-350-35-2 . Room for Debate Debate 10-1 Team 1 Arguments supporting the provisions of SFAS No. 115 Decision usefulness is the overriding objective of financial accounting. According to SFAC No. 8, financial statement should provide information that is useful to present and potential investors, creditors and others in making rational investment, credit and other decisions. The information provided should help users in assessing the amount, timing, and uncertainty of enterprise future cash flows so that they can assess the enterprise’s ability to meet obligations when due and other operating needs, to reinvest in operations, and to pay cash dividends. It should provide information regarding enterprise resources, claims to resources and how those resources are used in operations and other enterprise activities. The provisions of SFAS No. 115 (see FASB ASC 320) are intended to require preparers to report the economic substance of investments in securities. If those securities are purchased to realize short-term price appreciations, they are considered trading securities. They should be reported at fair value because this is the amount immediately realizable. Since the intent is to sell the securities within a relatively short time period, the holding gains and losses are also immediately realizable and should be reported as such. Fair value is also relevant to users when securities that are available for sale. Fair value measures what the assets are worth in the market. 149

Fair value provides information regarding the working capital that is available to pay current liabilities. For those securities that are to be held to maturity, there is no intent to sell, hence, fair value is not relevant. The classifications of securities and their accounting treatments under SFAS No. 115 also provide information that is reliable. Reliability implies that the information presented is representationally faithful. According to SFAC No. 8, representational faithfulness is correspondence or agreement between a measure or description and the phenomenon it purports to represent. Accounting phenomena to be represented and reported are economic resources and obligations and the transactions and events that change those economic resources and obligations. Fair value provides representationally faithful measures of securities. The securities are capable of realizing fair value. Also, because fair value for these securities is readily determinable in the market place, it is neutral. Presenting marketable securities at fair value in the balance sheet is consistent with the economist’s view of wealth and thus, the changes in fair value, holding gains and losses, should enter into the calculation of income. SFAS No. 115 is consistent with the economist’s view of income, a view which is closer to physical capital maintenance then financial capital maintenance, because holding gains and losses for trading securities are included in income. Moreover, holding gains and losses for available-for-sale securities are now included in comprehensive income. The measurement of the assets in the balance sheet at fair value is consistent with the physical capital maintenance concept of income because if the assets were replaced they would be replaced at fair value. However, the inclusion of holding gains and losses in income is inconsistent with physical capital maintenance, but consistent with financial capital maintenance as interpreted by the FASB. Finally, the provisions of SFAS No. 115 partially eliminate the unevenhanded treatment of gains and losses afforded by the lower-of-cost-or-market method required under its predecessor, SFAS No. 12. Under SFAS No. 12, management could manage earnings by stating that they intend to hold a security long-term or short-term. Gains and losses were recognized in income when the securities were short-term, but accumulated in equity when securities were long-term. As a result, a company could increase net income be including a security that had appreciated in value as short-term rather than long-term, but would not decrease net income if a security which declined in value were classified as long-term. Also, management was apparently selecting which securities to sell based on whether gains or losses would appear in the income statement. Team 2

Arguments describing the deficiencies of SFAS No. 115 One could argue that the cost method is the appropriate approach to account for any asset, including investments in the securities of other entities. Use of fair value to record assets is inconsistent with the stewardship role of accounting. Accordingly, the accountant should report the money investment of owners and how that money was spent to generate more money. Advocates of this argument contend that historical cost is the significant and relevant measure, at least to owners. Historical cost is relevant in providing investors with information on how capital was used in the business. In that sense it is relevant to users. Moreover, historical cost is reliable. It provides an objective, neutral, unbiased measurement base. One could also argue that lower-of-cost-or market is preferred as the only reasonable departure from historical cost. This argument is based on the notion that when the asset declines in value it has lost utility (service potential) and should be written down. However, writing the asset 150

back up above historical cost violates the historical cost principle. Moreover, it also violates the notion of conservatism. On the other hand one could approve of fair value accounting for SFAS No. 115 and still criticize the pronouncement as not going far enough. First, the scope limitation of SFAS No. 115 allows companies that are not subject to its provisions to continue practices which are different from companies who must comply. These differences would limit comparability between companies who continue the specialized practices and those who comply with the provisions of SFAS No. 115, because their financial statements would reflect different accounting approaches. Companies utilizing specialized practices would recognize gains and losses in their income statements that would not be recognized by companies complying with SFAS No. 115. As a result it may be difficult to explain similarities or differences between these companies’ reported net incomes and earnings per share or even between amounts reported as gains and losses in their respective income statements. Second, the classification of securities as available-for-sale still allows management to manipulate net income. If a security declines in value, management can say that the security is not intended to be a trading security and thereby avoid the negative impact on net income. If a security increases in value, management can increase net income by designating the security as trading. Third, the use of amortized cost for debt securities can result in a lack of comparability between companies who classify these securities as held-to-maturity and those who classify them as trading or available-for-sale. A similar argument can be made for differences in income between companies that classify securities as trading versus companies that classify similar securities as available-for-sale. Finally, the use of amortized cost can be criticized as not reporting the economic value of the asset to the company. For example, if the value increases the company could realize more by selling than by holding the asset. This kind of information is obscured by the use of amortized cost. Debate 10-2 Team 1. Present arguments in favor of the capitalization of “purchased” goodwill. You may consider tying your arguments to theories of capital maintenance and/or the conceptual framework. The primary argument for capitalization of purchased goodwill is that it meets the definition of an asset. Thus, it satisfies the qualitative characteristic of representational faithfulness and which allows us to fulfill the objective of usefulness. 1.

Definition of assets

SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Purchased goodwill is an asset. It represents the amount that the purchaser was willing to pay over and above the fair value of the acquired company’s net assets. As such, it is a measure of additional value of the company, as a whole. Economic theory tells us that a purchaser will not pay more for something than it is worth in an arms’ length transaction. Thus, the inference in the case of purchased goodwill is that the additional amount paid was paid for something of 151

value. Accountants believe that this extra value is related to the acquired company’s ability to generate returns in excess of those generated by a typical company in the same industry. The purchase price of an asset is equal to the present value of future cash flows. Hence, the amount paid for goodwill represents the present value of those expected future cash flows and goodwill is an asset. 2.

Objectives of financial reporting

Decision usefulness requires that companies report the status of enterprise resources. As stated above, goodwill provides future service potential. As such, it meets the definition of an asset found in SFAC No. 6, and must be reported as an asset so that the acquiring company can report the status of enterprise resources. 3.

Representational faithfulness

The qualitative characteristic of reliability requires representational faithfulness of items reported. Since goodwill meets the definition of an asset, it must be reported in the balance sheet as an asset so that assets reported in the balance sheet will represent what they purport to represent. 4.

Capital maintenance

Theories of capital maintenance require that income measurement be based on changes in net assets. Since goodwill is an asset, appropriate measurement of net assets, and thus capital maintenance requires that it be included as an asset so that when its value changes (such as an impairment) such changes can be incorporated into the measure of income. Team 2. Present arguments against the capitalization of “purchased” goodwill. You may consider tying your arguments to theories of capital maintenance and/or the conceptual framework. The primary argument against capitalization of purchased goodwill is that the excess amount paid for a business may not represent goodwill at all, or at best only part of it would. Therefore purchased goodwill, even if parts of it represent assets, all of it doesn’t and thus it should not be reported as an asset. Purchased goodwill, as currently measured, is likely to be a combination of a number of unidentifiable items, some of which might actually be goodwill. It may simply be the result of ability to bargain on the part of the selling company, and may not represent any excess earnings capacity. It may represent a control premium that the purchaser is willing to pay, just to own the acquired company, and as such does not represent goodwill. It could include other intangible assets that are not readily identifiable. Therefore, purchased goodwill, in a particular situation, may not meet the definition of an asset, or only part of it might. Because of the uncertainty associated with the nature of any excess payment to purchase a company, we cannot say that it is an asset. Thus, to report goodwill as an asset may violate representational faithfulness. The assets reported, when goodwill is included, may or may not be assets. If so, the qualitative characteristic of reliability would be violated.

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In addition, including a non-asset as an asset would result in improper measurements of capital maintenance. If all or part of goodwill is not an asset, it should be written off in the year of purchase. If not, then income is overstated in the year of purchase. At a later date, if the goodwill is deemed to be impaired, income for the future period would be understated. In other words, proper matching of revenue and cost would not occur. Debate 10-3 The Fair Value Option Team 1 Reporting financial assets and liabilities at fair value provides decision-relevant information to users. Under the fair value option investments in financial assets and liabilities are reported in the balance sheet at fair value. And, all changes in fair value are reported in earnings. Also, all financial assets to which the fair value option is applied are classified as trading securities. Companies may elect this option even for investments that heretofore were reported using the equity method. The fair value option allows users to better evaluate a company’s investment strategies. It displays what the assets are worth and reporting gains and losses in earnings provides income numbers reflecting increases and decreases in wealth resulting from those strategies. It also discloses the effects of management’s choice to keep the asset (i.e., to reinvest in the asset by choosing not to dispose of it). Treating these assets as trading securities also has merit. Management may dispose of these assets in the market place whenever they choose. The results are unbiased reporting that could occur by allowing management to pick and choose how they will treat a financial asset based on proclaimed “management intent”. Similarly, reporting financial liabilities at fair value has merit because the resulting balance sheet and income statement amounts display the results of management’s decision not to extinguish debt. If, for example, interest rates fall the fair value of debt would rise. To extinguish the debt in the market would require payment at the higher value. The extra cost would decrease company wealth. The fair value option would require management to report the potential decrease in earnings. Finally, we feel that SFAS No. 115 is inadequate because it does not cover financial assets that are not traded in organized exchanges. As a result, those financial assets that are not covered by SFAS No. 115 will be treated differently, even when management’s intention for their disposal is the same as that of assets that are covered by SFAS No. 115. Also, investments in assets over which a company has significant influence are really no different than investments in assets covered by SFAS No. 115. They may be actively traded and could be disposed at any time. Team 2 We are opposed to the fair value option. We feel that the other methods that are required to account for financial assets and liabilities are adequate. Management strategies for investing in financial assets differ and we feel that those differences should not be disguised by treating investments in financial assets as trading securities regardless of management’s intent. Those investments over which management has significant influence are not typically investments that will be sold in the near future. Fair value for these assets will not be realized 153

and, thus need not be disclosed. Instead, they are similar to business ownership. We feel that the equity method best displays the results of this type of investment strategy. SFAS No. 115 is intended to disclose the results and financial position of investments in financial assets. Investments that management does not intend to sell in the near future to realize short term gains are different from trading securities. If management does not plan to sell those assets in one year or the current operating cycle, whichever is longer, they should not be reported as trading securities. So, we feel that the fair value option basically means that the FASB believes that the intent of SFAS No. 115 is not valid. If so, then there should not be an “option” and all investments in financial assets should be treated the same. Because some financial assets are not traded, opting to report them at fair value would entail use of estimates of fair value that may not be reliable. If so, the option would compromise the reliability of the resulting financial statements and could result in biased reporting, and thus a loss of transparency. Finally, we do not agree that financial liabilities should be reported at fair value. If management does not plan to extinguish the debt in the market place, the company will never have to pay fair value. WWW Case 10-9 a.

Theoretically yes. These costs are incurred to organize the business and get it ready for business. Hence, they benefit the business over its life because they were incurred so the business could act as a business and generate future cash flows. As such, they represent future benefits of the entity resulting from past transactions or events.

Yes. They lack physical substance. They benefit the entity over its useful life, i.e., are long term. The amount of the benefit is difficult to measure (a typical characteristic of intangible assets)

Under the provision of FASB ASC 720-15-25-1, organization costs are expensed as incurred. This treatment was originally required by AICPA Statement of Position 98-5 which noted that some companies were expensing start-up costs while other companies were capitalizing them, using a variety of periods over which to amortize the costs. This disparate treatment of these costs diminished the comparability of companies' financial statements. Accordingly, Sop 98-5 sought to bring uniformity to the treatment of start-up and organization costs by dictating that these costs be expensed as incurred.

If the cost of intangibles benefit the business over its life, then because the life of the organization is indefinite (essentially perpetual for a corporation), a strong argument can be made for deferring organization costs and not amortizing them at all.

Case 10-10 a.

The reporting of available-for-sale securities at fair value provides the financial statement user with more relevant financial information. The fair value of the securities is essentially the present value of the securities’ future cash flows and so this helps investors and creditors assess the entity’s liquidity. Also, the fair value of the securities helps the financial statement user to 154

assess the entity’s investment strategies. The financial statements of the entity will reflect which investments have increased in fair value and which investments have decreased in fair value. However, since these securities have not been purchased with the intention of selling them in the near future, the portfolio is not managed to the same degree as trading securities. Therefore, if changes in the fair value of the available-for-sale securities were also included in earnings, the possibility exists that earnings could potentially be very unstable. Thus, to reduce this concern, any changes in fair value of the available-for-sale securities are excluded from earnings and instead recorded as other comprehensive income and as a separate component of stockholders’ equity. b.

Garcia Company should record the following journal entry and then report the following amounts on its balance sheet. December 31, 2013 Unrealized Holding Gain or Loss—Equity Fair Value Adjustment (Available-for-Sale)

1,100 1,100

Balance Sheet—December 31, 2013 Long-term investment: Equity investments (Available-for-sale), at cost Less: Fair value adjustment Equity investments (Available-for-sale), at fair value

$49,500 1,100 $48,400

Stockholders’ equity: Common stock Paid-in capital in excess of par-common stock Retained earnings Accumulated other comprehensive loss Total stockholders’ equity

$XXX XXX XXX (1,100) $ XXX

Investments classified as available-for-sale securities should initially be recorded at their acquisition price. The valuation of these investments is subsequently reported at their fair value. Any changes in the fair value of the investments are recorded in an unrealized holding gain or loss account, which is included as other comprehensive income and as a separate component of stockholders’ equity. Assuming the company prepared a statement of comprehensive income, it would show an unrealized holding loss of $1,100 during the period. c.

No, Garcia Company did not properly account for the sale of the Summerset Company stock. The cost basis of the Summerset stock is still $9,500. Therefore, Garcia should have recorded a $300 ($9,200 – $9,500) loss on investments as follows: Cash 9,200 Loss on Sale of Investments 300 Equity Investments (Available-for-Sale) 9,500

December 31, 2014 Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or Loss—Equity

1,500 1,500

Available-for-sale securities are reported at their fair value. Therefore, an adjusting entry must be made to show the $400 excess of fair value over cost in the portfolio. The unrealized holding 155

loss from the previous period must be reversed. As a result, $1,500 adjustment is needed to correctly state the available-for-sale portfolio. Securities Cost Greenspan Corp. stock $20,000 Tinkers Company stock 20,000 Total of portfolio $40,000 Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.

Fair Value $19,900 20,500 $40,400

Unrealized Gain (Loss) $ (100) 500 $ 400 (1,100) $1,500

he reporting of available-for-sale securities at fair value provides the financial statement user with more relevant financial information. The fair value of the securities is essentially the present value of the securities’ future cash flows and so this helps investors and creditors assess the entity’s liquidity. Also, the fair value of the securities helps the financial statement user to assess the entity’s investment strategies. The financial statements of the entity will reflect which investments have increased in fair value and which investments have decreased in fair value. However, since these securities have not been purchased with the intention of selling them in the near future, the portfolio is not managed to the same degree as trading securities. Therefore, if changes in the fair value of the available-for-sale securities were also included in earnings, the possibility exists that earnings could potentially be very unstable. Thus, to reduce this concern, any changes in fair value of the available-for-sale securities are excluded from earnings and instead recorded as other comprehensive income and as a separate component of stockholders’ equity Case 10-11 a.

Research, as defined in GAAP (FASB ASC 730-10-25), is “planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service . . . or a new process or technique . . . or in bringing about a significant improvement to an existing product or process.”Development, as defined in GAAP (FASB ASC 730-10-25), is “the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.”

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In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (1) associating cause and effect, (2) systematic and rational allocation, and (3) immediate recognition. The FASB found little or no evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits. The FASB also stated that the high degree of uncertainty surrounding future benefits, if any, of individual research and development projects make it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods. In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the “immediate recognition” principle of expense recognition should apply. The high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category. c.

The following costs attributable only to research and development should be expensed as incurred: Design and engineering studies. Prototype manufacturing costs. Administrative costs related solely to research and development. The cost of equipment produced solely for development of the product ($500,000). The remaining $1,500,000 of equipment should be capitalized and shown on the statement of financial position at cost, less accumulated depreciation. The depreciation expense resulting from the current year is a part of research and development expense for the year. The market research direct costs and related administrative expenses are not research and development costs. These costs are treated as period costs and are shown as expense items in the current income statement.

Case 10-12 a.

A dollar to be received in the future is worth less than a dollar received today because of an interest or discount factor—often referred to as the time value of money. The discounted value of the expected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1.

If the royalty receipts are expected to occur at regular intervals and the amounts are to be fairly constant, their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are expected. On the other hand, if receipts are expected to be irregular in amount or if they are to occur at irregular intervals, each expected future receipt would have to be multiplied by the present value of 1 for the number of periods of delay expected. In each case some interest rate (discount factor) per period must be assumed and used. As an example, if receipts of $10,000 are expected each six months over the next ten years and an 8% annual interest rate is selected, the present value of the twenty $10,000 payments is equal to $10,000 times the present value of an annuity of 1 for 20 periods at 4%. Twice as many periods as years and half the annual interest rate of 8% are used because the payments are expected at semiannual intervals. Thus the discounted (present) value of these receipts is $135,903 ($10,000 X 13.5903). Because of the interest rate, this discounted value is considerably less than the total expected collection of $200,000. Continuing the example, if instead it is expected that $10,000 will be received six months hence, 157

$20,000 one year from now, and a terminal payment of $15,000 is expected 18 months hence, the calculation is as follows: $10,000 X present value of 1 at 4% for 1 period = $10,000 X .96154 = $9,615. $20,000 X present value of 1 at 4% for 2 periods = $20,000 X .92456 = $18,491. $15,000 X present value of 1 at 4% for 3 periods = $15,000 X .88900 = $13,335. Adding the results of these three calculations yields a total of $41,441 (rounded), considerably less than the $45,000 total collections, again due to the discount factor. c.

The basis of valuation for patents that is generally accepted in accounting is cost. Evidently the cartons were developed and the patents obtained directly by the client corporation. Those costs related to the research and development of the cartons must be expensed in accordance with GAAP. The costs of securing the patent should be capitalized. If the infringement suit is unsuccessful, an evaluation of the value of the patent should be made to ascertain the reasonableness of carrying forward the patent cost. If the suit is successful, the attorney’s fees and other costs of protecting the patent should be capitalized and amortized over its remaining useful or legal life, whichever is shorter.

Intangible assets represent rights to future benefits. The ideal measure of the value of intangible assets is the discounted present value of their future benefits. For Steinfield Company, this would include the discounted value of expected net receipts from royalties, as suggested by the financial vice-president, as well as the discounted value of the expected net receipts to be derived from Steinfield Company’s production. Other valuation bases that have been suggested are current cash equivalent or fair market value.

The amortization policy is implied in the definition of intangible assets as rights to future benefits. As the benefits are received by the firm, the cost or other value should be charged to expense or to inventory to provide a proper matching of revenues and expenses. Under the discounted value approach, the periodic amortization would be the decline during the year in the present value of expected net receipts. In practice, generally straight-line amortization is used because it is simple and provides a uniform amortization approach. Another approach would be the units-of-production method.

The litigation should be mentioned in notes to the financial statements. Some indication of the expectations of legal counsel in respect to the outcome can properly accompany the statements. It would be inappropriate to record a contingent asset reflecting the expected damages to be recovered. Costs incurred to September 30, 2014, in connection with the litigation should be carried forward and charged to expense (or to loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been instituted; however, the conventional treatment would be to charge these costs as ordinary legal expenses. If the final outcome of the litigation is successful, the costs of prosecuting it should be capitalized. Similarly, if the client were the successful defendant in an infringement suit on these patents, the generally accepted accounting practice would be to add the costs of the legal defense to the Patents account. Developments between the balance sheet date and the date that the financial statements are released would properly be reflected in notes to the statements as post-balance sheet (or subsequent events) disclosure.

Case 10-13

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The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution.. Financial Analysis Case Answers will vary depending on company selected

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CHAPTER 11 Case 11-1 a.

The nominal interest rate, expressed as a percentage of the face value, is used to determine the periodic payment promised in a bond indenture. The effective interest rate is the rate at which bonds can be sold in the market. The nominal and effective rates of interest will be the same only when bonds are sold at face value. If bonds sell at less than face value (a discount), the effective rate is higher than the nominal rate. If bonds sell at more than face value (a premium), the effective rate is lower than the nominal rate.

The $25,000 difference is the adjustment of the nominal interest rate specified in the bond indenture to the market rate. In other words, for an investment of $975,000 the Company's bondholders will receive an annual interest payment of $40,000 plus $25,000 more than they invested when the bonds mature. Though earned throughout the life of the bond contract the bondholders do not receive this portion of the "effective" interest until maturity. This difference is disclosed on the balance sheet as a contra liability in the Discount on Bonds Payable account.

The $10,000 increase in the market value of the bonds from January I to June 30 is primarily the result of a decrease in the rate of interest at which the Company's bonds will trade in the market. The decrease in the market rate of interest at which the bonds will trade may be due to a general change in the conditions of the bond market, to a change in the Company's credit ratings or to a combination of the two. A minor portion of the increase is due to the fact that the bonds were issued at a discount and are now six months closer to maturity. This portion of the increase is due only to the passage of time and would have taken place without any change in the market rate of interest. In other words, assuming no change in the market rate of interest, the market value of the bonds will increase gradually from $975,000 to $1,000,000 at maturity because of the increase in the present value of the unpaid but accruing interest (discount) of $25,000. Assuming the discount is accumulated on an interest basis, this position of the increase in the market value of the bonds will be reported in the Company's financial statements. The portion of the increase in the market value of the bonds which is due to the decrease in the market rate of interest, though not reported in the financial statements, is significant because only by comparing the effective rate of interest at which the bonds were issued with the current market rate of interest can the Company judge whether or not the rate they are paying is advantageous to them. If the market rate is lower it may be to the Company's advantage to refund the old issue even though the funding itself would result in a loss.

$975,625. This basis for valuing the bond liability--its effective amount as at the date of the issue, plus accumulated discount on a straight-line basis for the six months since then--is theoretically superior to the other three. It would; however, be more precise to accumulate the discount on an interest basis. 160

The Company actually borrowed $975,000, and the immediate liability incurred cannot be more nor less than this amount. The present value of the bond liability is less than maturity value because the effective rate of interest is greater than the nominal rate which appears on the face of the bonds. The actual difference between the present value of the bond liability at the date of issue ($975,000) and its maturity value ($1,000,000) represents that portion of the effective interest on the amount borrowed ($975,000) that will not be paid until maturity. As this amount is accumulated by charges to interest expense and credits to the bond liability, the effective amount of the liability gradually approaches maturity value.

$1,000,000. This basis for valuing bond liabilities, the amount due at maturity, is widely used in practice. Its use is frequently supported on the grounds that it represents the amount of true legal liability, since it is this amount that would be due and payable in the event of default. This support disregards the accounting assumption of the going concern and, instead, emphasizes liquidation values. This valuation basis is also supported on the grounds that the discount represents prepaid interest and should therefore be classified as an asset. This argument has no merit because the discount represents unpaid interest, not prepaid interest. Any bookkeeping entry which classifies discount as prepaid interest does so only by failing to properly adjust to amount borrowed to its effective amount. The practice of recording bond liabilities at maturity value and setting up the discount as a deferred charge is defensible only if the amounts involved are not material and it can be shown that this treatment is expedient. $1,780,000. The basis for this alternative--the total amount the Company is obligated to repay over the remaining life of the bonds ($1,000,000 at maturity, plus 39 semiannual interest payments of $20,000 each)--has no justification. It would require the difference between the amount actually borrowed ($975,000) and the total amount the Company became obligated to repay ($1,800,000) to be treated as an asset or a loss when the bonds were issued. To assume that assets were acquired in excess of the amount actually borrowed or that a loss was incurred in an arm's-length transaction is indefensible. The original bondholders invested $975,000 for the right to receive $1,800,000 under the conditions stipulated in the contract (an annuity of $20,000 for forty periods and $1,000,000 at the end of the fortieth period). Thus, at the date of issuance the Company incurs a liability equal to the amount of the bondholders' investment. The difference between this amount and $1,800,000 is the total amount of interest which will accrue with the passage of time. It does not exist at the date the bonds are issued. Except for the materiality of the amounts involved, the use of this alternative as a valuation basis suffers from the same theoretical shortcomings as does the use of face value when bonds are issued at a discount. Case 11-2 a.

Under current GAAP (FASB ASC 470-60, previously SFAS No. 15) for restructured debt where there is a modification of terms, the debtor recognizes a gain on troubled debt restructure when the total future cash flows are less than the book value of the restructured debt. Whiley Company will recognize a gain on troubled debt restructuring of $10,000 in the income statement, calculated as follows: 161

Current book balances: Note Payable Interest Payable Total future cash flows under the new agreement Gain on Troubled Debt Restructuring

$100,000 10,000

$110,000 100,000 $ 10,000

This requirement implies that the book value of the debt will be written down to equal the total future cash flows of $100,000. Therefore, Whiley Company will report the restructured liability at 12/31/14 at $100,000. Because the recorded value of the restructured debt is equal to the total future cash flows, there will be no interest expense recorded. That is, the debt will be treated as though the effective rate is zero. b.

Current GAAP for the creditor, Security, is found at FASB ASC 310-40, previously SFAS No. 114. According to this guidance, Security may report the restructured receivable at $75,815, the present value of the future cash flows. This value presumes that Security expects to receive all four payments. If Security believes that it is not probable that all of the $100,000 will be received, the present value of the expected amounts discounted at 10% should be reported. As an alternative, GAAP allows restructured receivables to be recorded at the loan's observable market price. Since the Whiley note has no observable market price, Security may not use this alternative. In addition, GAAP also allows a collateralized receivable to be record at the fair value of the collateral. In this case, the note is secured by equipment having a fair value of $80,000. As a practical matter, this amount would represent the minimum recoverable value of the receivable. Thus, theoretically, it represents the minimum value at which the creditor should report the restructured receivable. The effect on the income statement for 2014 would be that Security would recognize a loss for the difference between the recorded value of the restructured receivable and its book value immediately prior to restructure, as follows: 1. If the restructured receivable is recorded at its present value: Book value of receivable prior to restructuring Recorded value of restructured receivable Loss on Restructured Receivable

$110,000 75,815 $ 34,185

2. If the restructured receivable is recorded at the value of the collateral: Book value of receivable prior to restructuring Recorded value of restructured receivable Loss on Restructured Receivable 162

$110,000 80,000 $ 30,000

GAAP allows two alternatives for reporting income in the income statement. 1. Security may report changes in the present value due to the passage of time as interest revenue. When interest income is recognized, changes in the present value (or floor value) that are due to changes in expectations regarding future cash flows are reported as adjustments to bad debt expense. 2. All changes in the present value of expected future cash flows (or presumably the floor value) may be treated as adjustments to bad debt expense. c.

Under FASB ASC 470-60 previously, SFAS No. 15 the creditor, Security, would not recognize any loss. It is clear that due to the time value of money and the risk inherent in collecting the future cash flows, Security has suffered a loss. Hence, the asset (the restructured receivable) would be overstated. It is also evident that to allow the debtor more time, implies that there is income associated with the receipt of the future cash flows, assuming they are collected. Hence, this treatment can be viewed as providing financial statements that are more representationally faithful and relevant. Recording the restructured receivable at the present value of the expected cash flows has merit. Balance sheet values for receivables should reflect expectations about future cash flows. The FASB proposed that these cash flows should be discounted at the interest rate on the original financial instrument. This position is defended on the basis that the restructuring represents an effort to recover an existing debt and is not a new financial instrument. Opponents of this view counter that the restructuring is replacing the expected cash flows under the prior, original agreement, hence the interest rate used to discount the original debt instrument is no longer relevant. Recording the restructured receivable at the fair value of the collateral has merit in that this value could presumably be recovered. However, it could be argued that this value should serve only as a floor. If the present value of the expected future cash flows exceeds the fair value of the collateral, it would provide a more relevant measure of the future service potential of the asset.

If debtors were allowed to record the transaction in the same manner as creditors, Whiley would recognize a gain for the difference between the present value of the future cash flows and the prerestructure book value of the debt or for the difference between the fair value of the collateral and the prerestructure book value. These values would be equivalent to those reflected above in b. for Security. For example, under the assumption that Whiley will record the restructured debt at $75,815. Total debt would be less by $24,185 ($100,000 - 75,815) than it is under current GAAP. This measurement would have a positive effect on Whiley's debt to equity ratio. At the same time the gain recognized in the income statement would be greater by $24,185 ($34,185 - 10,000). This would increase EPS. Also, because the gain would be closed to retained earnings, the debt to equity ratio would be further enhanced. A similar balance sheet effect would occur in 2015. The debt would again be lower. Debt balance under current GAAP (100,000 - 25,000) 163

$75,000

Debt balance under creditor treatment Beginning balance $75,815 Interest at 10% 7,582 Payment received 25,000 Difference Retained earnings under current GAAP Beginning balance Interest expense

$83,397 58,397 $16,603

$10,000 $10,000

Retained earnings under creditor treatment Beginning balance $34,185 Interest expense ( 7,582) 26,603 Difference $ 16,603 However, the reported net income in future years would be less by the recognition of interest expense. There would be no difference in the effect on operating cash flows in the statement of cash flows. Case 11-3 a.

Convertible bonds are complex financial instruments comprising two fundamental financial instruments - debt and the option to convert. Financial economics suggests that each feature has value. Hence, the issue price of convertible debt is a function of the two sources of value. The theoretical accounting treatment for convertible bonds would be to separate the fair values of the debt and the option to convert, because it is felt that each has decision relevance to users. Many accounting theorists feel that the option to convert is an equity feature and if a separate value is reported for the option it should be reported as an element of stockholders' equity. This view is consistent with the argument that the value of the option is a function of the value of the stock. The option has value only because it can be converted into stock, hence it is in essence equity. Others contend that the option does not meet the definition of equity because option holders do not act as owners. Rather, they feel that the option is an obligation that should be reported as debt. It is an obligation to issue stock which when satisfied yields capital contributions that are less than what would have been infused into the company had the stock been sold at its then current market price. It is argued therefore, that the conversion is at the expense of preexisting stockholders, hence, the option holder is not acting as an owner. Proponents of this view hold that the value of the option should be separated from debt. Some feel that the separated value should be disclosed as debt, others feel that it should appear between debt and equity, as quasiequity. Under current generally accepted accounting principles, the value of the option to convert is not separated from debt. Rather the debt is recorded initially at its issue price, and no amount is reported for the option to convert, or equity feature. This treatment is considered practicable because there is no current consensus on how to independently or objectively value the option. 164

FASB Statement No. 150 requires mandatorily redeemable preferred stock not be disclosed within the stockholders' equity section of the balance sheet. Instead, it is disclosed as a liability This disclosure is required because the FASB feels that mandatorily redeemable preferred stock has characteristics that are more like debt than equity - i.e., that there is a probable future sacrifice of resources. However, the SEC does not allow the stock to be included in total liabilities. Hence the SEC appears to consider redeemable preferred stock as quasi equity.

If convertible debt is issued, the balance sheet would report $100,000 of bonds payable. Each year $10,000 in interest would be paid and reported as an expense. The interest would be tax deductible. Hence, the net effect on reported earnings would be the interest multiplied by one minus the tax rate. The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. Upon conversion, there would be no cash flow. The debt would be replaced by stock (equity securities) and the debt to equity ratio would improve. The company would have the alternative of recording conversion at book value or at fair value. If the fair value method is selected there would be an income statement gain or loss. The effect on preexisting stockholders would be that the after tax interest cash flows would be replaced by and may not be equal to dividend cash flows. However, unlike the redeemable preferred stock, the company would be able to retain its capital without resorting to alternative or new sources of financing. If redeemable preferred stock is issued, it would be recorded at its issue price. Under GAAP, the preferred stock would be debt and would appear on the balance sheet. The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. The preferred stock dividend payments would equal the interest payments that would have been made to the holders of the convertible debt, but the dividends would not provide a tax shield. Redemption would require a cash outflow, but would have no income statement effect.

The change from reporting the conversion feature as debt to equity would shift balance sheet numbers from debt to equity, thereby enhancing the debt to equity ratio for the convertible debt option and alleviating the constraint on debt covenant restrictions. However, management decisions should be based on economic consequences of alternatives. Managerial action should not be motivated merely by accounting representations. Whether the "equity feature" is reported as debt or equity will, in and of itself, have no cash flow effects and should therefore not affect management's decision. Hence, if the debt covenant restrictions are not a factor, management's decision to issue convertible debt versus redeemable preferred stock should not be affected. However, there is documented evidence is that consistent with the argument that management's decisions are affected by financial statement appearances. The decision to select one alternative over another may be affected by the debt covenant restrictions. If the classification of the "equity feature" materially affects the debt to equity ratio, then management may be more prone to select convertible debt because the debt provides a tax shield and no cash flow will be required to convert the debt to equity.

Case 11-4 165

The effective interest method of amortization of bond discount or premium applies a constant interest rate to the carrying value of debt as opposed to the straight-line method that applies a constant dollar amount over the life of the debt resulting in a changing effective rate paid based on the carrying value of the debt. Either method, however, computes the premium or discount to be amortized as the difference between the par value of the debt and the proceeds from the issuance.

Before the interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value effected for unamortized premium or discount). The amount of the amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument due to the decreasing carrying value of the bond instrument multiplied by the constant effective interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond due to the increasing carrying value of the bond instrument multiplied by the constant effective interest rate from which is subtracted the amount of cash interest paid. The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rate demanded in the marketplace.

The effective interest method of amortization does not provide an appropriate liability balance amount because the amount disclosed is not the amount necessary to retire the liability on the balance sheet date.

Case 11-5 a.

Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment 166

should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and nay unamortized premium or discount are actually adjustments to the actual effective interest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. b.

Recognizing the gain or loss from refunding debt in the period of extinguishment would provide a balance sheet measure that reflects the present value of the future cash flows discounted at the interest rate that is commensurate with the risk associated with the new debt issue. This measure is equivalent to the issue price of the new debt. The issue price of the new debt is set by the market. The market sets the issue price by discounting the future cash flows set forth in the debt instrument by the market rate of interest.

Recognizing the gain or loss from refunding debt in the period of extinguishment is the generally accepted approach. Originally, these gains and losses were classified as extraordinary, hoverer, in 2002 the FASB concluded that debt extinguishments that are used as a part of an entity's risk management strategy do not meet the criteria for classification as extraordinary items and therefore should not be classified as extraordinary.

Case 11-6 a.

Angela should report the estimated loss from the safety hazard as an expense in the income statement and a liability in the balance sheet because both of the following conditions were met. * *

It is considered probable that liabilities have been incurred. Based on past experience, a reasonable estimate of the amount of loss can be made.

In addition, Angela should disclose the nature of the safety hazard in the notes to the financial statements. b.

Angela should not report the estimated loss from the noninsurable flood risk as an expense in the income statement or a liability in the balance sheet because no losses have occurred since the warehouse has been uninsured and the asset has not been impaired. Thus, a loss should not be recognized and a liability does not exist. Furthermore, disclosure of the noninsurable risk in the notes to the financial statements is not required because no losses have occurred since the 167

warehouse has been uninsured. Disclosure in the notes to the financial statements is, however, permitted. c.

The purchase of movie tickets should be accounted for by debiting an asset account--movie tickets inventory--and crediting cash. An accrual for the estimated promotion expense and liability should be accounted for by debiting promotion expense and crediting an accrued liability for those costs associated with 60 percent of the coupons issued. The coupons actually redeemed this year should be accounted for by debiting the accrued liability and crediting the asset account--movie tickets inventory--for 40 percent of the coupons.

Case 11-7 a.

A note received in exchange for property, goods, or services should be recorded at its present value which is presumably the value of the property exchanged. In the case of a note bearing interest at a reasonable rate and issued in an arm's-length transaction, the face value of the note should be used, as explained below. A note received for property, goods, or services represents two elements which may or may not be stipulated in the note: (1) the principal amount, equivalent to the bargained exchange price of the property, goods or services as established between the seller and the buyer and (2) an interest factor to compensate the seller over the life of the note for the use of funds he would have received in a cash transaction at the time of the exchange. Notes so exchanged are accordingly valued and accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction in a manner similar to that followed for a cash transaction. When a note is exchanged for property, goods, or services in a bargained transaction entered into at arm's-length, there is a presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the seller for the use of the related funds. In these circumstances the note's present value is identical with its face value. Furthermore, where the rate of interest is reasonable and separately stated, the face value of the note is equal to the bargained exchange price for the property.

ii. When a note bears no interest (or has a stated interest rate that differs sharply from the prevailing rate) and/or is not issued in an arm's-length transaction, the present value must be determined through consideration of the economic substance of the transaction. The note and the sales price of the property, goods or services exchanged for the note should be recorded at the fair value of the property, goods, or services or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable. That amount may or may not be the same as the face amount; any resulting discount or premium should be accounted for as an element of interest over the life of the note. In the absence of established exchange prices for the related property, goods or services or evidence of the market value of the note, the present value of a note that stipulates no interest (or a rate of interest that differs sharply from the prevailing rate) should be determined by discounting all future payments on the note, using an imputed rate of interest as described below. This determination should be made at the time the note is issued; any subsequent changes in prevailing interest rates should be ignored. 168

The variety of transactions encountered precludes any specific interest rate from being applicable in all circumstances. However, some general guides may be stated. The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the collateral, payment, other terms pertaining to the debt, and the tax consequences to the buyer and seller. The prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate. In any event, the rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction. The objective is to approximate the rate that would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase that bears the prevailing rate of interest to maturity. b.

If the recorded value of a note differs from its face value, the difference should be treated as discount or premium and amortized as interest over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. This is the "interest" method. Other methods of amortization may be used if the results obtained are not materially different from those which would result from the "interest" method.

ii. The discount or premium is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium should be reported in the balance sheet as a direct deduction from or an addition to the face amount of the note. It should not be classified as a deferred charge or deferred credit. The description of the note should include the effective interest rate. A valid alternative would be to report the note at its net value, disclosing the face amount of the note and the effective rate of interest on the face of the financial statements or in the notes to the statements. Amortization of discount or premium should be reported as interest expense in the income statement. Case 11-8 a.

The market price of the term bonds would be the sum of the present values of all of the expected net future cash flows discounted at an effective annual interest rate (yield) of 10 percent. The net future cash outflows are the maturity amount (face value) and the series of future semiannual interest payments adjusted for accrued interest received. The market price of the serial bonds would be determined by computing the market price for each serial separately in the same way that a term bond would be determined and then totaling these prices for the various serials.

.i. Immediately after the term bond issue was sold, the current asset--cash--would be increased by the proceeds from the sale of the term bond issue. A noncurrent liability--term bonds payable--would be presented in the balance sheet at the face value of the term bonds, plus the premium. In addition, a current liability--accrued interest payable--would be presented in the balance sheet for accrued interest received (March 1, 2014, to Apri1, 2014). ii. Immediately after the serial bond issue was sold, the current asset --cash--would be increased by the proceeds from the sale of the serial bond issue. A noncurrent liability-169

serial bonds payable--would be presented in the balance sheet at the face value of the serial bonds, less the discount. b.

The bond issue costs incurred in preparing and selling the bond issue could be accounted for as a noncurrent asset--deferred charge, deducted from the proceeds of the bond issue or charged as an expense. Current GAAP allows bond issue costs to be deducted from the proceeds or charged as an expense.

To determine the amount of interest expense for the term bonds for 2014, the net carrying value of the term bonds on April 1, 2014, would be multiplied by the effective interest rate (yield) of 10 percent for 9/12 of the year. (April 1, 2014 to December 31, 2014) To determine the amount of interest expense for the serial bonds for 2014, the net carrying value of the serial bonds on November 1, 2014, would be multiplied by the effective interest rate (yield) of 11 percent and by one sixth (November 1, 2014. to December 31, 2014).

Case 11-9 The two basic requisites for the accrual of a loss contingency (probability of loss and reasonable estimation) are the results of the interaction of several concepts of accounting theory. Three of these concepts are (1) periodicity (time periods), (2) measurement, and (3) objectivity. The first of these concepts relates to the first characteristic of an event necessary before accruing a loss contingency, and the second and third concepts listed relate to the second necessary requirement for the accrual of a loss contingency. The first requirement that must be satisfied for the accrual of a loss contingency is that at a time prior to the issuance of the financial statements there is an indication that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements. A basic objective in the recognition of losses is to record them in the particular period in which they are incurred. With respect to the accrual of a loss contingency, a probable loss should be recognized in the same period in which it resulted in the probable impairment of an asset or the probable incurrence of a liability. The failure to accrue the loss contingency in the period of occurrence will generally overstate earnings initially and understate earnings in future periods. The second requirement for the accrual of a loss contingency states that the amount of the loss must be reasonably estimable. The concept of measurement requires that the event must be quantifiable in terms of a standard unit of measure (dollars). In the case of a loss contingency related to the period covered in the current financial statements, the exact timing and magnitude of the loss may not be known in advance, but based on past experience or other methods of analysis, a reasonable estimate of the loss contingency can be made. In making the estimate, the probability that a reasonable amount will be determined statistically is enhanced by a large population of accounts from which the probable loss will occur (law of large numbers). Also related to the reasonable estimation of the probable future loss, the concept of objectivity requires that the estimate be supported by quantitative data. The basis for the estimate must yield essentially the same estimate when computed by different individuals using the available supporting data. The concept of objectivity is supportive of the contention that future events will confirm the occurrence of a loss at the date of the financial statements. Of course the loss must be probable as well as estimable and justified in light of future events. 170

Relevant accounting information can make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Consequently, reasonable estimation of the probable future loss provides financial statement users with information that has predictive value, feedback value, and timeliness. Case 11-10 Situation 1 When a company sells a product subject to warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated and a probable dollar estimate of the liability can be made. The contingent liability for warranties meets both of the requirements for the accrual of a loss contingency, and the estimated amount of the loss should be reflected in the financial statements. In addition to recording the accrual, it may be advisable to disclose the factors used in arriving at the estimate by means of a footnote especially when there is a possibility of a greater loss than was accrued. Situation 2 Even though (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated and (3) the likelihood of the loss was discovered prior to the issuance of the financial statements, the fact that the contract was entered into subsequent to the date of the financial statements precludes accrual of the loss contingency in financial statements for periods prior to the incurrence of the loss. However, the fact that a material loss has been incurred subsequent to the date of the financial statements but prior to their issuance should be disclosed by means of a footnote in the financial statements. The disclosure should contain the nature of the contingency and an estimate of the amount of the probable loss or a range into which the loss will probably fall. Situation 3 The fact that a company chooses to self-insure the contingency of injury to others caused by its vehicles is not basis enough to accrue a loss contingency that has not occurred at the date of the financial statements. An accrual or "reserve" cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk. A loss contingency may only be accrued if prior to the date of the financial statements a specific event has occurred that will impair an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated. The fact that a company is self-insuring this risk should be disclosed by means of a footnote to alert the financial statement reader to the exposure created by the lack of insurance. FASB ASC 11-1 Disclosure of Liabilities by Not-For-Profit Entities The disclosure of liabilities for not-for-profit entities as found at FASB ASC 958-405. It is found by searching “liabilities and not-for-profit entities.” FASB ASC 11-2 Indirect Guarantees 171

Guidelines for accounting for indirect guarantees are found at FASB ASC 460-10-50. It can be accessed by searching “contingencies and indirect guarantees.” The pronouncement that clarified the issue was FIN 45. Found by using the Print with Sources function FASB ASC 11-3 Derivatives Implementation issues for SFAS N. 133 are found at FASB ASC 815-10-55 and can be accessed through the cross reference feature. After accessing the topic, u se the Print with Sources function. to answer the question. FASB ASC 11-4 The Fair Value Option and Health Care Businesses Search performance indicator Topic 954-825 FASB ASC 11-5 The Use Of Zero Coupon Bonds In A Troubled Debt Restructuring Search troubled debt restructuring and zero coupon Topic 310-40-55 FASB ASC 11-6 Accounting for Loss Contingencies by Regulated Entities Search regulated operations and loss contingencies Topic 980-450-25

FASB ASC 11-7 Hedging and Gas Balancing Arrangements Search gas balancing arrangement Topic 932-815-55 Room for Debate Debate 11-1 Team 1 Argue for presenting redeemable preferred stock as debt The SEC prohibits the presentation of mandatorily redeemable preferred stock as equity. Since, there are only three balance sheet elements, assets, liabilities and equity, if redeemable preferred stock is not equity, then it must be a liability under the present accounting model as described in the conceptual framework.

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SFAC No. 6 defines liabilities as the probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. This definition implies that a liability has three characteristics: (1) it embodies a present duty to another entity(ies) that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, on demand, (2) the duty obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (3) the transaction or other event obligating the entity has already happened. The first characteristic and third characteristics inherent in this definition are easily satisfied by examining the very nature of redeemable preferred stock. Mandatorily redeemable preferred stock embodies an obligation to redeem it at a specified price and time. It thus embodies a nondiscretionary obligation to transfer enterprise assets to the holder, which suggests that it may be a liability rather than equity. In addition, the transaction or event obligating the entity was the issuance of the preferred stock. The issue of whether mandatorily redeemable preferred stock is a liability hinges on determining whether the entity has little or no discretion to avoid the future sacrifice. First, mandatorily redeemable preferred stock is senior to all other stock of the enterprise. This seniority prohibits declaration or payment of dividends to other stock unless the full cumulative dividend has been declared and set aside for holders of redeemable preferred stock. Redemption is not optional on the part of either the issuer or the holder of the stock. Hence, the holder of redeemable preferred shares has a contractual right to receive cash at the specified time and to enforce a contractual provision not to pay dividends on other issues of stock if the preferred dividends have not been paid. And, at redemption, the holder has the right to receive the redemption price, which typically includes unpaid dividends. That right normally becomes a creditor’s interest at the redemption date. If the company were to declare bankruptcy, the holder of mandatorily redeemable preferred stock may be a member of the creditors’ committee that petitions a court for involuntary bankruptcy or reorganization of the debtor. However, the redemption value would not be included in determining insolvency, nor would the holder be able, by themselves, to place the issuer in involuntary bankruptcy. Thus it appears that owners of mandatorily redeemable preferred stock have essentially the same legal rights as creditors as long as the issuer is solvent and some of the same legal rights as creditors when the issuer is insolvent. Thus, it is argued that the mandatorily redeemable provisions converts what otherwise would be an equity instrument into a liability because the essence of a liability is the obligation to transfer assets to another party. As such, this debt instrument imposes a duty to sacrifice assets that the enterprise has little discretion to avoid. The obligation is virtually unavoidable because the only way it can be avoided is for the company to become financially incapable of paying a return to its owners. Team 2 Argue for presenting redeemable preferred stock as equity Redeemable preferred stock is characterized for legal purposes as “stock.” All financial instruments that are characterized for legal purposes as “stock” are therefore subject to restrictions on distributions to shareholders that stem from corporate law rather than contract. Hence, these securities should be considered equity instruments even when the issuer has a contractual obligation to redeem them. Whether the issuer can be required to satisfy its obligation to redeem depends on the adequacy of the assets and equity as defined by applicable legal provisions. The issuer may avoid the contractually required sacrifice of assets if the 173

applicable legal requirements for a distribution to owners are not met. For example, in a court of law, the amount due upon redemption of preferred stock cannot force a company into bankruptcy. Moreover, this amount due to holders of redeemable preferred stock is not includible in the determination of insolvency. Arguably, the effect of the redemption provision is analogous to cumulative dividends on nonredeemable preferred stock. Cumulative dividends do not become a liability until they become due and payment has effectively been declared. SFAC No. 6 defines equity as the residual interest in the assets of an entity that remains after deducting liabilities. If redeemable preferred stock does not meet the definition of a liability, it must be equity. Separate balance sheet classification of redeemable preferred stock (i.e., separate from equity) is not required under GAAP. All preferred stockholders are considered “stock” holders by law. They are treated in the same way as owners in liquidation - i.e., they are residual owners, but they have claims senior to all other classes of stock. Debate 11-2

Fair Value Option

Team 1

SFAS No. 159 (FASB ASC 825) allows users to measure financial assets and liabilities at fair value, providing an opportunity to mitigate reported earnings volatility without having to apply complex hedge accounting. Rather than designating a fair value hedging relationship under Statement 133, entities may elect to apply the fair value option to the hedged item at its inception. Reporting financial instruments at fair value and including unrealized changes in fair value in earnings would reflect the economic events in the periods in which they occur and faithfully represent the underlying economics—a key objective of the conceptual framework. Thus, the effect of a company’s credit worthiness on its capital structure would be reflected in balance sheet measurements of debt and equity. The FASB believes fair values for financial assets and financial liabilities provide more relevant and understandable information than cost or cost-based measures. The Board considers fair value measurements of financial instruments to be more relevant to financial statement users than cost-based measurements because fair value reflects the current cash equivalent of the entity’s financial instruments rather than the price of a past transaction. The FASB also believes that, with the passage of time, historical prices become irrelevant in assessing an entity’s current financial position. Reporting holding gains and losses for debt would reveal the results of management decision to pay or not pay off debt, to replace debt with new debt (that would reflect current market conditions and credit worthiness) and to substitute or not substitute debt for equity, or viceversa. In other words, the effects of credit-worthiness and changes in interest rates due to current economic conditions on firms are not captured using the historical cost model Team 2

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If you believe that current value should be applied to liabilities, then giving an option rather than a mandate to do so is inappropriate and could lead to biased reporting whereby management would pick and choose which liabilities to apply fair value to. Stated differently, providing an “option” to continue the use of historical-cost based measurement will lead to accounting that potentially misrepresents the underlying economics. We do not share the FASB’s belief that fair value measure of a company’s liabilities is preferable to historical cost. If management is not going to extinguish debt in the near term, then adjusting it to fair value will not provide the user to figures with which to project future cash flows (an objective of financial reporting, described in SFAC No. 8). Perhaps a criterion based on management intent would be preferable to providing a blanket option to elect fair value. However, past management practices of deceit would indicate that even this criterion would likely result in reduced, rather than enhanced financial statement transparency.

Debate 11-3 Convertible debt Should we separate the debt and equity features of convertible debt? Team 1: Pro Separation. Present arguments in favor of separating the debt and equity features of convertible debt. Convertible debt is a complex financial instrument. Complex financial instruments combine two or more fundamental financial instruments. Convertible debt combines two fundamental financial instruments – debt and equity (the option to convert). The conversion feature has a value that is derived from the value of the stock, not the debt. That value should be separated from the issue price of the convertible debt and reported in the balance sheet as equity, just like other options whose value derives from the value of stock are reported. Convertible debt can be converted into a predetermined number of shares of the issuing company’s capital stock. From the investor’s perspective, convertible debt has a value-added component built into it – the option to convert the debt into equity. As a result, the debt sells for more than it would, if it were issued as straight debt. This extra issue price is the value of the option to convert. The option is not debt and its value should be reported separately from the value of the debt itself. Stated differently, the issuing company has issued two things as a package deal to the investor – debt (a bond) and the option to convert the debt. The convertible debt can be viewed as similar to debt issued with warrants attach. The warrants give the investor the right to purchase equity shares at a predetermined price. Since this is an issuance of two things – debt and options to purchase shares the issue price is separated into its debt and equity components and reported in the balance sheet as debt and equity. We argue that the same treatment should be afforded to convertible debt. The value of the equity feature (the option to convert) should be separated from the value of the debt itself and the two items (debt and equity) should be reported separately in the balance sheet. Current accounting practice treats convertible debt as straight-debt. It does not separate the option to convert from the debt. We believe that this overstates the amount of debt owed by the company. As a result, the amount of interest expense reported in the income statement is 175

understated each accounting period. This makes the debt look like it was issued at a more favorable interest rate than it actually was. Team 2: Against Separation. Present arguments against the separation of the debt and equity features of convertible debt. According to APB Opinion No. 14, convertible debt should be reported in the balance sheet as straight-debt. We agree that the convertible debt is issued at a higher price than straight-debt is, but any value added due to the ability of the investor to convert the debt to equity shares is not separable from the debt. There is either debt of equity outstanding at any one time, not two different securities. Until conversion takes place, there is only debt outstanding. After conversion takes place, there is only equity outstanding. Convertible debt is not like debt that is issued with warrants. The warrants are separate securities. They can be sold or exercised. If the investor sells the warrants, the debt is still outstanding. If the investor exercises the right to purchase shares of stock, the debt is still outstanding. The debt and the warrants are clearly two separate securities. Conversely, the convertible debt is not two securities that can be separated and treated differently by the investor. It is an either or situation, the issuer has either a debt security or equity securities, never both. Another argument for treating convertible debt as straight-debt lies in the notion that it should be classified according to its governing characteristic. In other words, we ask whether the debt instrument satisfies the definition of a liability or equity at its issuance. At issuance, the company has an obligation to pay the principle and interest until conversion takes place. Thus, the contractual terms of convertible debt indicate that it is a liability. Secondly, the convertible debt instrument embodies an obligation to transfer financial instruments (the stock) to the holder, if and when the option to convert is exercised. Thirdly, we should classify in accordance with the fundamental financial instrument that has the higher value. At issuance, the debt component has a higher market value than the option to convert. WWW Case 11-11 a. 1. This is a common balance sheet presentation and has the advantage of being familiar to users of financial statements. The face or maturity value of $1,000,000 is shown in an obvious manner. The total of $1,085,800 is the objectively determined exchange price at which the bonds were issued. It represents the fair market value of the bond obligations given. Thus, this is in keeping with the generally accepted accounting practice of using exchange prices as a primary source of data. 2. This presentation indicates the dual nature of the bond obligations. There is an obligation to make periodic payments of $55,000 and an obligation to pay the $1,000,000 at maturity. The amounts presented on the balance sheet are the present values of each of the future obligations discounted at the initial effective rate of interest. The proper emphasis is placed upon the accrual concept, that is, that interest accrues through the passage of time. The emphasis upon premiums and discounts is eliminated. 3. This presentation shows the total liability which is incurred in a bond issue, but it ignores the time value of money. This would be a fair presentation of the bond obligations only if the effective-interest rate were zero. 176

When an entity issues interest-bearing bonds, it normally accepts two types of obligations: (1) to pay interest at regular intervals and (2) to pay the principal at maturity. The investors who purchase Weiss Company bonds expect to receive $55,000 each January 1 and July 1 through January 1, 2034 plus $1,000,000 principal on January 1, 2034. Since this ($55,000) is more than the 10% per annum ($50,000 semiannually) that the investors would be willing to accept on an investment of $1,000,000 in these bonds, they are willing to bid up the price—to pay a premium for them. The amount that the investors should be willing to pay for these future cash flows depends upon the interest rate that they are willing to accept on their investment(s) in this security. The amount that the investors are willing to pay (and the issuer is willing to accept), $1,085,800, is the present value of the future cash flows discounted at the rate of interest that they will accept. Another way of viewing this is that the $1,085,800 is the amount which, if invested at an annual interest rate of 10% compounded semiannually, would allow withdrawals of $55,000 every six months from July 1, 2014 through January 1, 2034 and $1,000,000 on January 1, 2034. Even when bonds are issued at their maturity value, the price paid coincides with the maturity value because the coupon rate is equal to the effective rate. If the bonds had been issued at their maturity value, the $1,000,000 would be the present value of future interest and principal payments discounted at an annual rate of 11% compounded semiannually. Here the effective rate of interest is less than the coupon rate, so the price of the bonds is greater than the maturity value. If the effective rate of interest was greater than the coupon rate, the bonds would sell for less than the maturity value.

1. The use of the coupon rate for discounting bond obligations would give the face value of the bond at January 1, 2014, and at any interest-payment due thereafter. Although the coupon rate is readily available while the effective rate must be computed, the coupon rate may be set arbitrarily at the discretion of management so that there would be little or no support for accepting it as the appropriate discount rate. 2. The effective-interest rate at January 1, 2014 is the market rate to Weiss Company for longterm borrowing. This rate gives a discounted value for the bond obligations, which is the amount that could be invested at January 1, 2014 at the market rate of interest. This investment would provide the sums needed to pay the recurring interest obligation plus the principal at maturity. Thus, the effective-interest rate is objectively determined and verifiable. The market or yield rate of interest at the date of issue should be used throughout the life of the bond because it reflects the interest obligation which the issuer accepted at the time of issue. The resulting value at the date of issue was the current value at that time and is similar to historical cost. Also, this yield rate is objectively determined in an exchange transaction. The continued use of the issue-date yield rate results in a failure to reflect whether the burden is too high or too low in terms of the changes which may have taken place in the interest rate.

Using a current yield rate produces a current value, that is, the amount which could currently be invested to produce the desired payments. When the current yield rate is lower than the rate at the issue date (or than at the previous valuation date), the liabilities for principal and interest would increase. When the current yield is higher than the rate at the issue date (or at the previous valuation date), the liabilities would decrease. Thus, holding gains and losses could be determined. If the debt is held until maturity, the total of the interest expense and the holding 177

gains and losses under this method would equal the total interest expense using the yield rate at issue date. Case 11-12 a.

1. The selling price of the bonds would be the present value of all of the expected net future cash outflows discounted at the effective annual interest rate (yield) of 11 percent. The present value is the sum of the present value of its maturity amount (face value) plus the present value of the series of future semiannual interest payments. 2. Immediately after the bond issue is sold, the current asset, cash, would be increased by the proceeds from the sale of the bond issue. A noncurrent liability, bonds payable, would be presented in the balance sheet at the face value of the bonds less the discount. The bond issue costs would be classified as either an expense or a reduction of the related debt liability.

Interest expense would be included for ten months (March 1, 2014, to December 31, 2014) at an effective-interest rate (yield) of 11 percent. This is composed of the nominal interest of 9 percent adjusted for the amortization of the related bond discount. Bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2014) to the maturity date (March 1, 2019).

The amount of bond discount amortization would be lower in the second year of the life of the bond issue. The effective-interest method of amortization uses a uniform interest rate based upon a changing carrying value which results in increasing amortization each year when there is a bond discount.

The retirement of the bonds would result in a loss from extinguishment of debt that should be included in the determination of net income and classified as an ordinary loss.

Case 11-13 a.

Before the effective-interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value adjusted for unamortized premium or discount). The amount of amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by the nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument. This is due to the decreasing carrying value of the bond instrument multiplied by the constant effective-interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond. This is due to the increasing carrying value of the bond instrument multiplied by the constant effective-interest rate from which is subtracted the amount of cash interest paid.

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The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rates demanded in the marketplace.

Part II. Before the effective-interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value adjusted for unamortized premium or discount). The amount of amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by the nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument. This is due to the decreasing carrying value of the bond instrument multiplied by the constant effective-interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond. This is due to the increasing carrying value of the bond instrument multiplied by the constant effective-interest rate from which is subtracted the amount of cash interest paid.

Part II. a.

1. Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. 2. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. 3. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the 179

value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and any unamortized premium or discount are actually adjustments to the actual effective-interest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. c.

The immediate recognition principle is the only acceptable method of reflecting gains or losses on the early extinguishment of debt, and these amounts, if material, must be reflected as ordinary gains and losses.

Case 11-14 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution.

Financial Analysis Case Answers will vary depending on the company selected.

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CHAPTER 12 Case 12-1 There is insufficient information to calculate the amount of depreciation that would be deducted from the $200,000 pretax accounting income if the purchase were made; hence, the solution will ignore it and concentrate only on the deferred tax impacts. a.

The projected amount of income tax expense that would be recognized if Whitley waits until next year to purchase the equipment is calculated as follows: Pretax accounting income Reversal of deductible amount Reversal of taxable amount Taxable income Tax rate Taxes payable Decrease in deferred tax asset Decrease in deferred tax liability (42,500 x 40%) Income tax expense

$200,000 (37,500) 42,500 $205,000 x 40% $ 82,000 15,000 (17,000) $ 80,000

The projected amount of income tax expense that would be recognized if Whitley purchases the equipment in 2013 is calculated as follows: Income tax expense, calculated in a. ncrease in deferred tax liability (50,000 x 40%) Income tax expense

$ 80,000 20,000 $100,000

If the goal of management is to improve the appearance of their financial statements, the purchase should be postponed. The following financial statement effects would occur if the purchase were made in 2013. Current assets (cash) would decrease by the amount of the purchase price. Long term assets would increase by the same amount less depreciation. Current liabilities would be unaffected. The result would be a decline in liquidity measures, such as the current ratio and working capital. The deferred tax increase would increase long-term liabilities. At the same time net income would decrease by the amount of depreciation expense and by the amount of the deferred tax liability increase. The effect would be to increase the debt to equity ratio. The decrease in net income would result in a decline in EPS. Ignoring depreciation expense on the acquired asset, the following differences in EPS would occur:

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EPS - Postpone purchase:($200,000 - 80,000)/55,500 = EPS - purchase in 2006: ($200,000 -100,000)/55,500 Decline in EPS

$ 2.16 1.80 $ 0.36

Not only would EPS decline if the purchase were made, but it would fall below the prior year EPS, $1.95. The company would no longer display the historic steadily increasing EPS. d.

The company would continue to project a steadily increasing EPS if the purchase were postponed. Although the EPS would be historically correct, i.e., representationally faithful, the projections implied by it may mislead potential investors, particularly, if next year is no better, or is even worse than 2013. The ethical dilemma is that a company should not base economic decisions on financial statement effects. Rather, the financial statements should portray economic reality regardless of what that reality is.

Case 12-2 a.

There is no clear solution to this exercise; it can be used to generate class discussion about the qualitative criteria originally contained is SFAC No. 2. The following represents the opinion of the authors. Nondiscounting (1)

Discounting (2)

1. Relevance a. Timeliness b. Predictive & feedback value

2. Reliability a. Representational Faithfulness b. Verifiability & neutrality

X X

3. Understandability

4. Comparability b.

Neither (3)

Relevance. Because the objective of financial statements is to provide decision relevant information, discounted deferred taxes may be more relevant than nondiscounted deferred taxes. The FASB has determined that the asset liability approach measures future tax consequences. It follows that deferred tax liabilities measure future cash outflows. Consistent with liability measurements of other future expected cash outflows the present value of the expected future tax consequences has decision usefulness and is therefore relevant. Timeliness. The concept of timeliness, as a qualitative criterion, means that the information provided in financial statements is presented within a time frame to be decision relevant. The measurement method (discounting vs. nondiscounting) does not affect the timeliness of either approach. 182

Predictive and feedback value. If we believe that deferred taxes are future tax consequences, and that they should be measured in a manner that is consistent with other liabilities in order to be decision relevant, then it follows that discounting provides better predictive and feedback value because it provides an appropriate measure of actions taken and as such should improve decision maker abilities to predict the results of future actions. ii. Reliability. When assessing the reliability of accounting representations, the degree of representational faithfulness must be weighed against verifiability and neutrality. Again, if future cash outflows (liabilities) are better represented by their present value, then discounting deferred taxes has representational faithfulness. Representational faithfulness. Representational faithfulness implies that the financial information reported reflects what it is purported to represent. Because deferred tax liabilities measure future cash flows, the time value of money would imply that a part of the future cash flow is for interest and therefore, the present value of those cash flows provides a representationally faithful measure of the liability. b.

Verifiability and Neutrality. It could be argued that the selection of an interest rate appropriate to discount deferred tax liabilities is subjective or even arbitrary. If so, there would be a much greater degree of consensus among independent measurers if the deferred taxes were not discounted. Also, because subjectivity inherent in the selection of an interest rate would be avoided, nondiscounted deferred taxes would be more neutral. Understandability. Presuming that users understand the nature of deferred taxes and present value, neither method would provide financial statements that would be more understandable than the other. Comparability. Because other, significant liabilities are measured at present value, financial statements containing discounted deferred tax liabilities should provide greater comparability across time and among companies. The amounts of the various reported liabilities would be more comparable as well as aggregated data across firms.

Supporters of discounting deferred taxes argue that the present value of liabilities provides measures that are more representationally faithful. If deferred taxes portray future tax consequences (cash outflows) and those tax consequences are liabilities, then because of the time value of money they should be discounted. As a result, discounted deferred taxes provide better measures of future cash flows, and are thus more relevant. By deferring taxes, the company is economically better off, and discounting better reflects the resulting well-offness. Also, discounting deferred taxes is consistent with measurements of other liabilities such as notes and bonds.

Opponents of discounting deferred taxes argue that the result is a mismatching of the deferred tax consequences with the temporary differences and reversals causing them to occur. Moreover, discounting conceals the actual tax burden by reporting part of the future tax consequences as interest expense. Finally, it can be argued that there is no interest expense because the government is in effect making an interest free loan to the company; hence, there is no interest rate with which to discount the deferred taxes. 183

Case 12-3 a.

Intraperiod income tax allocation is necessary to obtain an appropriate relationship between income tax expense and each element of earnings (continuing operations, discontinued operations and extraordinary items, or between income tax expense and prior-period adjustments. Income tax expense attributable to earnings before extraordinary items is computed based solely on the earnings before extraordinary items to prevent distortion of the results of continuing operations. The extraordinary items are shown net of the corresponding income tax consequences. Any prior-period adjustment is shown net of the corresponding income tax consequences as an adjustment to beginning retained earnings.

Some accountants cite the argument that income taxes are an expense rather than a distribution of earnings. They apply the matching concept of accrual accounting, thus relating the income taxes presented on the earnings statement to the earnings that gave rise to those taxes. Their argument is that income tax expense for financial reporting should be related to the respective pretax accounting earnings. Implicit in this argument is the notion that a distribution of earnings is not allocated to periods.

Under the guidance contained at FASB ASC 740 (original pronouncement SFAS No. 109), deferred tax accounts reflect deferred, future tax consequences. The tax consequences of temporary differences between taxable income and pretax accounting income that will result in future taxable income greater than future pretax accounting income (future taxable amounts) represent the deferral of tax payments and are considered liabilities. The tax consequences of temporary differences between taxable income and pretax accounting income that will result in future taxable income less than future pretax accounting income (future deductible amounts) represent future benefits and are therefore considered assets. In addition, NOL carryovers and unused tax credits embody future tax benefits which are considered assets. The deferred tax assets and liabilities are measured by projecting the future tax consequences and calculating their balance sheet amounts using tax rates that will be in effect in future years based on currently enacted tax law. The deferred tax assets may be reduced by a valuation allowance if it is more likely than not that some or all of their future benefits will not be realized. At the balance sheet date, a determination is made as to whether deferred tax assets (net of their valuation allowance) and deferred tax liabilities are current or noncurrent. Deferred taxes are considered current or noncurrent based on whether the related balance sheet accounts are classified as current or noncurrent. For example, a deferred tax liability would be classified as noncurrent if it results from a temporary difference in depreciation because the related net plant asset is classified as noncurrent. If there is no related balance sheet account, the determination is made based on whether reversal is expected to occur within the operating cycle or one year, whichever is longer. In the balance sheet, current deferred tax assets are netted against current deferred tax liabilities. A resulting net liability is reported as a single amount as a current liability. A resulting net asset is reported as a single amount as a current asset. Noncurrent deferred tax assets and liabilities are netted and reported in a similar manner as a single noncurrent asset or liability amount.

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.i. Temporary difference. The full estimated three years of warranty expenses reduce the current year's pretax accounting earnings, but will reduce taxable income in varying amounts each respective year, as incurred. Assuming the estimate as to each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for a given warranty. This is an example of an expense that, in the first period, reduces pretax accounting earnings more than taxable income and, in later years, reverses and reduces taxable income without affecting pretax accounting earnings.

ii.

Permanent difference. This difference in depreciation for pretax accounting earnings and taxable income will never reverse because the depreciation is based on different recorded amounts of the assets in question. The income tax expense per books would be reflected based on the amount actually paid (or due) in this situation.

iii.

Temporary difference. The investor's share of earnings of an investee (other than subsidiaries and corporate joint ventures) accounted for by the equity method is included in pretax accounting earnings, while only dividends received are included in taxable income. This difference between pretax accounting earnings and taxable income is assumed to be related either to probable future dividend distributions or to anticipated realization on disposal of the investment and is a factor in determining income tax expense. Future dividends imply ordinary income, and future disposal of an investment implies capital-gains income. Because dividend income is subject to an 85% dividends-received deduction, the effective rate would, in this case, be lower for the ordinary dividend income than for capital gains.

Estimated warranty costs (covering a three year period) that are expensed for accounting purposes when incurred result in future deductible amounts because they are not deductible for tax purposes until paid. The resulting tax benefit is a deferred tax asset. Normally equity method income will exceed the taxable portion of dividends received. A reversal would therefore be a taxable amount and would result in a deferred tax liability.

Case 12-4 a.

The term "temporary differences" is the differences between taxable and financial accounting income that occur either because revenue is recognized in one period for income tax purposes and in a different period for accounting purposes or because expenses are recognized in either an earlier or later period for accounting purposes than for tax purposes. Temporary differences are also caused by management decisions regarding the timing of tax payments. This difference will reverse in some later period.

Examples of temporary differences contained at FASB ASC 740-10-25-20 (original pronouncement SFAS No. 109) include: 1. Revenues or gains that are taxable after they are recognized in financial accounting income. 2. Expenses or losses that are deductible after they are recognized in financial accounting income. 3. Revenues or gains that are taxable before they are recognized in financial accounting income. 185

Expenses or losses that are deductible before they are recognized in financial accounting income.

A reduction in the tax basis of depreciable assets because of tax credits.

The investment tax credit accounted for by the deferred method.

Foreign operations for which the reporting currency is the functional currency.

An increase in the tax basis of assets because of indexing for inflation.

Business combinations accounted for by the purchase method.

SFAS No. 109 defends interperiod tax allocation on the basis that temporary differences have future tax consequences. They therefore result in deferred tax assets and deferred tax liabilities. The recognition of deferred tax assets and liabilities affects the amount reported for income tax expense. This effect is consistent with the definition of earnings as changes in net assets attributable to non-owner events and transactions. Interperiod tax allocation can also be defended as being consistent with the matching concept, even in the context of SFAS No. 109. If the future tax consequences argument holds, the effect of applying SFAS No. 109 is to match in the current accounting period, the expected, deferred tax consequences of transactions and events reported in the income statement with their future tax consequences measured at the tax rate expected to occur when the reversal is expected to take place, given currently enacted tax law. Changes in tax rates in future periods due to changes in tax law are treated as changes in estimate in a manner consistent with other balance sheet and income statement items.

Case 12-5 a.

Under the provisions of SFAS No. 109, the criteria for recognizing a deferred tax liability specify that a temporary difference has future tax consequences resulting in a liability when the reversal is a future taxable amount. If so, according to SFAS No. 109, the resulting deferred tax consequences meet the definition of liabilities found in SFAC No. 6. That is, the deferred taxes obligate the entity to pay future taxes in excess of the amount that would be paid if there were no reversal, and the obligation results from a prior transaction or event, the occurrence of the temporary difference. The criteria for recognizing a deferred tax asset specify that a temporary difference has future tax consequences resulting in an asset when the reversal is a future deductible amount. Also, a NOL carryforward and unused tax credits have future benefit and are considered assets. Recognition of the asset is constrained by the more likely than not criterion that may limit the amount of deferred tax assets in the balance sheet by a valuation allowance. According to SFAS No. 109, the resulting deferred tax assets meet the definition of assets found in SFAC No. 6. They embody future benefit to the entity resulting from prior transactions or events (the occurrence of the temporary difference or the presence of the NOL carryforward or unused tax credit).

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The asset/liability method of interperiod tax allocation is balance sheet oriented. The intent is to accrue and report the total tax benefit or taxes payable that will actually be realized or assessed on temporary differences when they reverse. A temporary difference is viewed as giving rise to either a tax benefit that will result in a decrease in future payments, or a tax liability that will be paid in the future at the then-current tax rates. When using the asset/liability method, income tax expense is the sum (or difference between) the changes in deferred tax asset and liability balances, and the current provision for income taxes per the tax return. Under this approach, deferred taxes meet the conceptual definition of assets and liabilities established in SFAC No. 6. The deferred method of income tax allocation is an income statement approach. It is based on the concept that income tax expense is related to the period in which income is recognized. The tax effect of a temporary difference is the difference between income taxes computed with and without the inclusion of temporary differences. The resulting difference between income tax expense and income taxes currently payable is an increase or decrease to the deferred tax account.

Case 12-6 a.

Proponents of no allocation of income taxes believe that income tax expense should be equal to the current year provision for taxes. The following are arguments defending this position. 1. Income taxes result from taxable income, not accounting income. Thus, attempts to match taxes with accounting income are irrelevant. 2. Income taxes are not like other expenses, therefore, they should not be allocated in a manner similar to other expenses. Other expenses are costs of generating revenue. Income taxes generate no revenue. They are not incurred in anticipation of future benefit, nor are they expirations of cost incurred to provide facilities that generate revenue. 3. Income taxes are levied on total taxable income, not individual items of revenue or expense. Hence, there are no temporary differences between taxable income and accounting income. 4. Tax allocation hides economic differences between a company that employs tax savings strategies from one that does not. 5. Reporting tax expense equal to taxes paid provides a better predictor of future cash flows because many deferred taxes will never be paid. 6. Tax allocation presumes implicit forecasts of future profits, a practice which is inconsistent with conservatism. 7. Deferred tax liabilities do not meet the definition of a liability. There is no present obligation to the future taxes reported as deferred tax liabilities. There is no prior transaction because there is no legal liability until an actual tax return is filed. 8. The cost of doing interperiod tax allocation exceeds the benefits, if any, derived.

Proponents of partial allocation of income taxes propose that interperiod tax allocation is appropriate for items that will reverse, but not for others. They cite the following arguments to defend their position. 1. Many temporary differences are not like items such as accounts payable. Accounts payable “roll over” as the result of individual transactions each of which is individually paid. Because income tax is based on total taxable income, consideration of the effects of groups of items is appropriate. 2. Comprehensive income tax allocation distorts economic reality. For many items there is no “roll over” because the tax rules persist, and the company continues to repeat the same 187

economic transactions (e.g., purchase fixed assets). Thus, consideration should be give to the impact of the future, as well as to historical transactions. 3. Partial allocation enhances assessments of future cash flows. The deferred taxes reported would be more reflective of expected cash flow. 4. Comprehensive allocation is a rigid mechanical approach, which inherently results in the distortion of economic reality. c.

Proponents of comprehensive allocation of income taxes argue that all temporary differences have future tax consequences and those tax consequences should be reported in the balance sheet as assets and liabilities. No allocation or partial allocation distorts the presenting of the economic facts because neither approach matches the items reported in the income statement with their tax cash flow effects. The following arguments support this position. 1. Individual temporary differences do reverse. They are temporary, not permanent. Thus, the focus should be on individual items not on groups of items. 2. Accounting is historical. It is inappropriate to offset the income tax effects of possible future transactions against the tax effects of transactions that have already occurred. 3. Temporary differences result in future tax consequences. Hence, the expected tax effects should be reported in the same period as the related transactions and events in pretax financial accounting income. 4. Accounting should not be subjected to manipulation. Management should not be allowed to affect (bias) results by selecting which tax effects resulting from temporary differences should be recorded and which should not.

Case 12-7 a. i. Gross Profit on Sales Operating Expenses Rent Expense Taxable Income Tax rate Taxes paid

2017 $350,000 210,000 60,000 $ 80,000 x30% $24,000

2018 $349,000 210,000 0 $139,000 x30% $ 41,700

2019 $351,000 210,000 0 $141,000 x30% $ 42,300

Net Income

56,000

97,300

98,700

2017 $350,000 210,000 20,000 $120,000 36,000 $ 84,000

2018 $349,000 210,000 20,000 $119,000 35,700 $ 83,300

2019 $351,000 210,000 20,000 $121,000 36,300 $ 84,700

ii. Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense @ 30% Net Income

The student may have his/her own opinion regarding this question. We believe that no allocation does distort net income. The company has performed essentially the same for all 188

three years, yet no allocation gives the appearance, looking at net income, that the company performed significantly better the latter two years, almost twice as well. c.i.

2017 $350,000 210,000 20,000 $120,000 36,000 $ 84,000

Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense Net Income

2018 $349,000 210,000 20,000 $119,000 39,870 $ 79,130

2018 Tax expense: $139,000 x 33% = 20,000 x 30% =

2019 $351,000 210,000 20,000 $121,000 40,530 $ 84,700

$45,870 ( 6,000) $39,870

2019 Tax expense: $141,000 x 33% = 20,000 x 30% =

ii. Gross Profit on Sales Operating Expenses Rent Expense Income before taxes Tax Expense Net Income

2017 $350,000 210,000 20,000 $120,000 36,000 $ 84,000

$46,530 ( 6,000) $40,530 2018 $349,000 210,000 20,000 $119,000 40,470 $ 79,130

2019 $351,000 210,000 20,000 $121,000 39,930 $ 81,070

2017

Deferred Tax Liab. = 40,000 x 30%

$12,000

2018

Deferred Tax Liab. = 20,000 x 33% Decrease Taxes paid

2019

Deferred Tax Liab. = Decrease Taxes paid

6,600 $(5,400) 45,870 $40,470 0 ( 6,600) $46,530 $39,930

The asset/liability approach provides measures that are more useful. The asset/liability approach reports the deferred tax liability at the amount expected to be paid when the temporary difference reverses - i.e., when tax is paid on the taxable amount. The deferred method reports the deferred tax liability measured at the old tax rate. Hence, it does not reflect the expected cash outflow and the measurement is not consistent with the measurement implied in the definition of a liability as the probable future sacrifice.

FASB ASC 12-1 Tax Effect of Translation Adjustment 189

Accounting for foreign currency translation adjustments is located at FASB ASC 830. It can be found by searching tax effect of translation adjustment. FASB ASC 12-2 Interpretations of SFAS No. 109 Found by accessing topic 740 through the cross reference function and using the Printer Friendly with Sources function. FASB ASC 12-3 Undistributed Earning of a Subsidiary Search income taxes and undistributed earnings of subsidiaries 740-30-25 FASB ASC 12-4 Deferred Tax Benefits for the Oil and Gas Industry Search oil and income taxes 932-740-30 In applying the comprehensive interperiod income tax allocation provision, the possibility that statutory depletion in future periods will reduce or eliminate taxable income in future years shall be considered in determining whether it is more likely than not that the tax benefits of deferred tax assets will not be realized FASB ASC 12-5 Special Temporary Difference for Steamship Companies Search industry-U. S. steamship and income taxes 995-740-25 FASB ASC 12-6 Temporary Differences for Entities Operating in Foreign Countries Search Temporary differences for foreign operations 740-10-55 FASB ASC 12-7 Deferred Taxes in the Casino Industry Use industry link-entertainment- casino- income tax 924-740 Room for Debate Debate 12-1 Team 1 Defend the deferred method of accounting for income tax expense

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The deferred method of income tax expense is grounded on the assumption that income tax expense is related to the period in which income is recognized. Under the deferred method income tax expense is measured as though the current period pretax financial accounting income is reported in the current year’s income tax return. The tax effect of a temporary difference is measured as the difference between income taxes computed with and without the inclusion of the temporary difference. The resulting difference between income tax expense and income taxes currently payable is a debit or credit to the deferred income tax account. The deferred method is based on the matching concept. The tax effects of temporary differences are matched with the temporary differences when they originate and reverse. The matching concept is important to income reporting because of the going concern assumption. Since business entities are presumed to be going concerns, enterprise performance must be assessed at intervals. That is, accountants must report periodically to investors, creditors and other users. Periodic reporting requires that accountants report on the performance of the entity during an accounting period so that users can assess enterprise how well the enterprise is utilizing resources to generate future cash flows for operations, reinvestment in operations, and dividends for investors. Some contend that the deferred tax balances resulting from application of the deferred method are meaningless because they result from the calculation of tax expense, i.e., they do not meet the definition of assets or liabilities. However, the income statement is the most important financial statement, and matching is a critical aspect of the accounting process. Thus, it is of little consequence whether deferred tax debits or credits meet the definition of assets or liabilities in the conceptual sense. Because the deferred method matches tax expense with all items reported in the income statement regardless of when they appear in the tax return, the resulting deferred taxes are the result of historical transactions or events that created the temporary differences. Since accounting reports most economic events on historical cost basis, deferred taxes should be reported in a similar manner. Historical cost is objective, verifiable, and neutral. It fulfills the stewardship function of accounting and is the cornerstone of the traditional accounting model. Accounting numbers should be reliable. The historical tax rates used to compute income tax expense and thus the deferred tax balances are historical rates and as such are objective, verifiable, and neutral. As a result their use increases the reliability of accounting information. Team 2 Defend the asset/liability method of accounting for income tax expense The asset/liability method of accounting for income tax expense is balance sheet oriented. Under the asset/liability method, the tax benefits or liabilities that will be realized or assessed on temporary differences when they reverse. The result is the reporting of the future tax consequences of prior and present temporary differences between pretax financial accounting income and taxable income. Because the asset/liability approach reports future tax consequences, the measurement of the expected future assessment or benefit is based on tax rates that will be in effect (under currently enacted tax law) when the taxable or deductible amounts resulting from temporary differences occur. The resulting deferred tax assets and liabilities have predictive ability because the balance sheet amounts are measures of expected future resource flows. This approach is superior to the 191

deferred method which measures deferred taxes at the originating rate, which does not measure expected tax benefits or assessments. Because of the measurement approach used, the deferred tax assets and liabilities reported under the asset/liability approach meet the definitions of assets and liabilities found in SFAC No. 6. Deferred tax assets can be viewed as embodying probable future benefits because they represent amounts of tax that are recoverable when future taxable income is less than accounting income (deductible amounts). Deferred tax liabilities meet the definition of liabilities because they represent amounts that will be assessed when future taxable income is greater than financial accounting income (taxable amounts). As such this approach increases the predictive ability of items in the balance sheet, increases the ability to assess liquidity as well as financial flexibility. The asset/liability approach to measuring deferred taxes provides balance sheet measures that are relevant to assess future resource flows. The balance sheet is becoming more important. There is an increased tendency to rely upon changes in assets and liabilities to indicate income statement measures. Such measures are consistent with the definition of comprehensive income and as well the economic concept of income as well. Debate 12-2 Discounting Deferred Taxes Team 1. SFAS No. 109stated that the asset and liability approach to accounting for income taxes is consistent with the definitions in FASB Concepts Statement No. 6, Elements of Financial Statements. Liabilities are defined in paragraph 35 of Concepts Statement 6 as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events". Accordingly, liabilities comprise three characteristics. The FASB argued that deferred tax liabilities have all three characteristics. The first characteristic of a liability is that it "embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand". Taxes are a legal obligation imposed by a government, and an obligation for the deferred tax consequences of taxable temporary differences stems from the requirements of the tax law. A government levies taxes on net taxable income. Temporary differences will become taxable amounts in future years, thereby increasing taxable income and taxes payable, upon recovery or settlement of the recognized and reported amounts of an enterprise's assets or liabilities. The second characteristic of a liability is that "the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice”. An enterprise might be able to delay the future reversal of taxable temporary differences by delaying the events that give rise to those reversals, for example, by delaying the recovery of related assets or the settlement of related liabilities. A contention that those temporary differences will never result in taxable amounts, however, would contradict the accounting assumption inherent in the statement of financial position that the reported amounts of assets and liabilities will be recovered and settled, respectively; thereby making that statement internally inconsistent. For that reason, the Board concluded that the only question is when, not whether; temporary differences will result in taxable amounts in future years. The third characteristic of a liability is that "the transaction or other event obligating the entity has already happened". Deferred tax liabilities result from the same past events that create taxable temporary differences.

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According to current GAAP, liabilities should be reported in the balance sheet at the present value of the future cash flows discounted at the market rate of interest. We argue that since deferred tax liabilities are considered “liabilities”, they should be given the same treatment as other liabilities. As such they should be measured and reported as the present value of the expected future tax outflows. Proponents of reporting deferred taxes at their discounted amounts argue that the company that reduces or postpones tax payments is economically better off. It is their belief that by discounting deferred taxes, a company best reflects the operational advantages of its tax strategies in its financial statements. Proponents also feel that discounting deferred taxes is consistent with the accounting principles established for such items as notes receivable and notes payable, pension costs, and leases. They argue that discounted amounts are considered to be the most appropriate indicators of future cash flows. In short, the time value of money is important to the well-being of companies, and because of this aspect, GAAP requires interest to be imputed for non-interest bearing financial instruments. It follows that the time value of money is enhanced by postponing tax payments, thus, consistency under GAAP would require imputing interest on deferred taxes. Team 2. FASB No. 109 omitted discounting from its scope. The result is that discounting deferred taxes is not allowed. Critics of discounting counter that discounting deferred taxes mismatches taxable transactions and their related tax effects. If companies discount deferred taxes, the amount of tax reported will be less than the amount of tax that will eventually be paid. The result would be that the future cash flows would be divided between interest and principal amounts. This would cause part of the deferred tax amount to be recognized in future periods as interest expense. So, the tax related to income statement items in one period would not be reported in the same period as the income statement items, rather some would be recognized over several periods as interest expense. As a result, discounting deferred taxes would conceal a company’s actual tax burden by reporting as interest expense the discount factor that would otherwise be reported as part of income tax expense. Furthermore, deferred taxes may be considered as interest-free loans from the government that do not require discounting because the effective interest rate is zero. The government will not charge interest on income tax unless it is a past due amount resulting from filing a tax return. No tax return has been files for deferred taxes, thus, there is no interest expense. Debate 12-3 Income Tax Allocation The FASB requires comprehensive interperiod income tax allocation using the asset/liability approach. Some feel that there should be only partial interperiod income tax allocation. Others feel that there should not be any interperiod income tax allocation. Team 1: Present arguments favoring no allocation of income taxes We believe that it is inappropriate to give any accounting recognition to the tax effects of differences between accounting income and taxable income. A company should report the 193

results of transactions and events. The difference between taxable income and accounting income is neither a transaction nor an event. Instead, the amount of income tax expense reported on a company’s income statement should be the same as the income taxes payable for the accounting period as determined by the income tax return. Thus, there should be no interperiod allocation of income taxes. Our position is buttressed by the following arguments. First, income taxes result only from taxable income. In so far as income tax is concerned, whether or not the company has accounting income is irrelevant. Hence, attempts to match income taxes with accounting income provide no relevant information for users of published financial statements. Moreover, income taxes are levied on total taxable income, not on individual items of revenue or expense. Therefore, there can be no temporary differences related to these individual items. Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues. They are simply period costs that are incurred as obligations to the government as a result of operating the total business at a taxable profit for the tax year. In our opinion, interperiod tax allocation hides an economic difference between a company that employs tax strategies in order to reduce current tax payments (and as a result, is economically better off) and one that does not. According to SFAC No. 8, financial statements should provide information that is useful for the reader to evaluate the performance of the company and thus to determine its value. Obscuring the economic benefits that result from effective tax strategies may mislead a potential investor and thus may result in suboptimal allocation of economic resources. SFAC No. 8 also states that financial information should help the user to predict future cash flows. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid, or will be paid only in the distant future. Another argument against income tax allocation is that it entails an implicit forecasting of future profits. For example, a deferred tax liability implies that there will be taxable income in the future on which income taxes will be paid. Also, a deferred tax asset implies that there will be future taxable income that can be offset or reduced by a future deductible amount, otherwise the deferred tax asset provides no future benefit. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism. It also violates the concept of representational faithfulness because a deferred tax liability may never be paid, or the deferred tax asset may never be realized. In these cases they do not meet the definitions of liabilities or assets. We believe that the most powerful argument against any income tax allocation is that there is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared. If there is no obligation to pay taxes on any future taxable amounts, how can the deferred tax liabilities meet the definition of a liability. Since no tax return has been prepared that includes the future taxable amounts and no taxes are due until a tax return is prepared, there has been no event or transaction to cause a liability to have been incurred. 194

Finally, although we believe that income tax allocation provides no benefits, even if it did, in our opinion, the accounting recordkeeping and procedures involving interperiod tax allocation are too costly for the purported benefits. Therefore income tax allocation violates the cost constraint described in SFAC No. 8. We oppose any allocation of income tax – comprehensive or partial. With regards to partial income tax allocation, we believe that management may pick and choose those temporary differences to which they wish to apply income tax allocation. Accounting results should not be subject to manipulation by management. That is, a company’s management should not be able to alter the company’s results of operations and ending financial position by arbitrarily deciding which temporary differences will and will not reverse in the future. Team 2: Present arguments favoring partial allocation of income taxes We believe that some temporary differences between accounting income and taxable income will reverse in the future. However, some temporary differences will never reverse because they are continuously replaced by others. Thus, the income tax expense reported in an accounting period should not be affected by those temporary differences that are not expected to reverse in the future. Stated differently, in certain cases, groups of similar transactions or events may continually create new temporary differences in the future that will offset the realization of any taxable or deductible amounts, resulting in an indefinite postponement of deferred tax consequences. In effect, we argue that these types of temporary differences are more like permanent differences. Examples of these types of differences include depreciation for manufacturing companies with large amounts of depreciable assets and installment sales for merchandising companies. We offer the following arguments to counter the arguments of our nonallocationist opponents. Firstly, income taxes result from the incurrence of transactions and events. If the company incurs taxable revenues, taxable income and thus taxes payable increase. If the company incurs tax deductible expenses, taxable income and thus taxes payable decrease. Without these transactions, there would be no taxable income and no taxes payable. Thus, the amount of income tax expense reported during an accounting period should take into consideration the results of those transactions and events that are included in financial accounting income. However, all groups of temporary differences are not similar to certain other groups of accounting items, such as accounts payable. Accounts payable “roll over” as a result of actual individual credit and payment transactions. Income taxes, however, are based on total taxable income and not on the individual items constituting that income. Therefore, consideration of the impact of the group of temporary differences on income taxes is the appropriate viewpoint. Applying income tax allocation to all temporary differences as is done for comprehensive income tax allocation is inappropriate. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions.

195

Instead, we believe that only those temporary differences that will reverse will result in future cash flows and thus result in deferred tax amounts that meet the definitions of assets and liabilities. In these cases, there will be probable future benefits that are eventually realizable from deferred tax assets and probably future cash outflows that will eventually be incurred from deferred tax liabilities. Thus, the resulting deferred tax assets and liabilities that are reported under partial income tax allocation will be assets and liabilities and will meet the qualitative characteristic of relevance. They will help the user to determine the financial position of the company and as well as its performance. Moreover, because they will results in eventual future cash flows, the assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows than either comprehensive tax allocation or no income tax allocation. Team 1’s arguments are flawed. Nonallocation of a company’s income tax expense hinders the determination of the company’s assets and liabilities as well as the prediction of its future cash flows. For those temporary differences that will reverse, nonalloction will distort the balance sheet and the income statement. Items that meet the definitions of liabilities and assets and are measurable will not be reported. Future cash flows that will result from the partial recognition of deferred tax assets and liabilities will not be readily determinable. The user will only see the current period obligation for income taxes that result from items reported in the income statement, not the impact on income taxes that will result from both present and future cash flows resulting from transactions and events that have already occurred. WWW Case 12-8 When income tax rates increase, the new rate is used to calculate deferred tax assets and liabilities. Hence, both deferred tax assets and liabilities would increase. An increase in deferred tax assets would decrease income tax expense. Hence, net income for a company with deferred tax assets would increase. Alternatively, an increase in deferred tax liabilities would increase income tax expense and result in a decrease in net income. Decreases in tax rates would have the opposite effects. Case 12-9 a.

The objectives in accounting for income taxes are: 1. To recognize the amount of taxes payable or refundable for the current year. 2. To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns.

To implement the objectives, the following basic principles are applied in accounting for income taxes at the date of the financial statements: 1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. 2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and loss carryforwards using the enacted marginal tax rate. 3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. 196

4. The measurement of deferred tax assets is adjusted, if necessary, to not recognize tax benefits that, based on available evidence, are not expected to be realized. c.

The procedures for the annual computation of deferred income taxes are as follows: 1. Identify: the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period. 2. Measure the total deferred tax liability for taxable temporary differences using the enacted tax rate. 3. Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the enacted tax rate. 4. Measure deferred tax assets for each type of tax credit carryforward. 5. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Case 12-10 a.

1. Temporary difference. The full estimated three years of warranty costs reduce the current year’s pretax financial income, but will reduce taxable income in varying amounts each respective year, as paid. Assuming the estimate as to each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for a given warranty. This is an example of an expense that, in the first period, reduces pretax financial income more than taxable income and, in later years, reverses. This type of temporary difference will result in future deductible amounts which will give rise to the current recognition of a deferred tax asset. Another way to evaluate this situation is to compare the carrying value of the warranty liability with its tax basis (which is zero). When the liability is settled in a future year an expense will be recognized for tax purposes but none will be recognized for financial reporting purposes. Therefore, tax benefits for the tax deductions should result from the future settlement of the liability. 2. Temporary difference. The difference between the tax basis and the reported amount (book basis) of the depreciable property will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered (through use or sale of the asset); hence, it is a temporary difference. 3. Temporary difference and permanent difference. The investor’s share of earnings of an investee (other than subsidiaries and corporate joint ventures) accounted for by the equity method is included in pretax financial income while only 20% of dividends received from some domestic corporations are included in taxable income. Of the amount included in pretax financial income, 80% is a permanent difference attributable to the dividendsreceived deduction permitted when computing taxable income. Twenty percent of the amount included in pretax financial income is potentially a temporary difference which will reverse as dividends are received. If the investee distributes 10% of its earnings, then onehalf of the potential temporary difference is eliminated and 10% of the amount included in pretax financial income is a temporary difference. 4. Temporary difference. For financial reporting purposes, any gain experienced in an involuntary conversion of a nonmonetary asset to a monetary asset must be recognized in the period of conversion. For tax purposes, this gain may be deferred if the total proceeds are reinvested in replacement property within a certain period of time. When such a gain is 197

deferred, the tax basis of the replacement property is less than its carrying value and this difference will result in future taxable amounts. Hence, this is a temporary difference. 5. Permanent difference. Life insurance premiums on employees are never deductible for income tax purposes 6. Permanent difference. Interest on municipal bonds is never taxable. 7. Temporary difference. The full amount of the sale is included in current income; whereas, only the annual amount of cash collected is reported as taxable income. This temporary difference will reverse in future years as the full sales priced is collected. b.

Deferred tax accounts are reported on the balance sheet as assets and liabilities. They should be classified in a net current and a net noncurrent amount. An individual deferred tax liability or asset is classified as current or noncurrent based on the classification of the related asset or liability for financial reporting. A deferred tax asset or liability is considered to be related to an asset or liability if reduction of the asset or liability will cause the temporary difference to reverse or turn around. A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including deferred tax assets related to loss carryforwards, shall be classified according to the expected reversal date of the temporary difference. Thus, a deferred tax account may be reported as a current asset, a current liability, a noncurrent asset or a noncurrent liability. Generally, a noncurrent deferred tax asset appears in the “Other assets” section of the balance sheet while a noncurrent deferred tax liability appears in the “Long-term liabilities” section

Case 12-11 A review of the compliance with the reporting requirement of Sarbanes-Oxley by the FASB discovered that many of the problems associated with compliance with its Section 404 were related to tax issues and as a result numerous financial statement restatements were required. Most specifically, the use of tax contingencies had become too flexible and was used to manipulate income and the reporting and disclosure of tax positions lacked transparency. The SEC was also concerned about the reporting of tax contingencies, and many SEC comment letters were issued on this issue In response to the above voiced concerns, the FASB undertook a project to determine how to account for uncertain tax positions. The result of this project was FIN No. 48 that establishes the proper accounting treatment for uncertain tax positions. The validity of a tax position is a matter of tax law, and it is not controversial to recognize the benefit of a tax position in an firm’s financial statements when there is a high degree of confidence that a particular tax position will be sustained after examination by the IRS. However, in some cases, tax law is subject to varied interpretations, and whether a tax position will ultimately be sustained may be uncertain. The evaluation of a tax position under FIN No 48 is a two-step process: 1. Recognition: A firm determines whether it is more likely than not that a tax position will be sustained upon examination by the IRS based on the technical merits of the position. In evaluating whether a tax position has merit, a firm is to use a more-likely-than-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information. 2. Measurement: A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The 198

tax position is measured at the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Case 12-12 The main changes contained in the proposed new IAS No 12 are: 1.

A change in the definition of tax basis. Tax basis would be defined as: the measurement under applicable substantively enacted tax law of an asset, liability or other item. 2. A specification that the tax basis of an asset is determined by the tax deductions that would be available if the entity recovered the carrying amount of the asset by sale. 3. The introduction of an initial step to determine deferred tax assets and liabilities so that no deferred tax arises if there will be no effect on taxable income when the entity recovers or settles its carrying amount. 4. New definitions of tax credit and investment tax credit as: i. Tax credit is a tax benefit that takes the form of an amount that reduces income tax payable. ii. Investment tax credit is a tax credit that relates directly to the acquisition of depreciable assets. 5. Removal of the initial recognition exception in IAS No. 12. 6. Changes to the exception in IAS No. 12 from the temporary difference approach relating to a deferred tax asset or liability arising from investments in subsidiaries, branches, associates and joint ventures. 7. A proposal to recognize deferred tax assets in full, less, if applicable, a valuation allowance to reduce the net carrying amount to the highest amount that is more likely than not to be realizable against taxable income. 8. A proposal that current and deferred tax assets and liabilities should be measured using the probability-weighted average amounts of possible outcomes assuming that the tax authorities will examine the amounts reported to them by the entity and have full knowledge of all relevant information. 9. Clarification that the term ‘substantively enacted’ as it relates to income tax legislation means that future events required by the enactment process historically have not affected the outcome and are unlikely to do so. 10. A change to the requirements relating to the tax effects of distributions to shareholders. An entity would measure current and deferred tax assets and liabilities using the rate expected to apply when the tax asset or liability is realized or settled, including the effect of the entity’s expectations of future distributions. 11. Adoption of the FASB ASC requirements for the allocation of income tax expense to the components of comprehensive income and equity. In particular, some changes in tax effects that were initially recognized outside continuing operations would be recognized in continuing operations. 12. The classification of deferred tax assets and liabilities as either current or non-current on the basis of the financial reporting classification of the related non-tax asset or liability. 13. A clarification that indicates the classification of interest and penalties is an accounting policy choice and hence must be applied consistently, and introduction of a requirement to disclose the chosen policy. Case 12-13

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Answers will vary depending on the companies selected.

200

CHAPTER 13 Case 13-1 a.

There is not enough information presented in the case to determine earnings, but the effect of the leasing alternatives on earnings can be determined. Dagger capitalizes the lease, causing the following earnings effects: The present value of the $20,000 payments, discounted at 8% is $86,242 (20,000 x 4.3121). Because this amount is less that the fair value of the asset, $96,000, the asset and associated liability will be recorded at $86,242. Depreciation and interest for 2014 will be: Interest expense [(86,242 - 20,000) x 8%] Depreciation expense (86,242 / 5) Before tax decrease in earnings

$ 5,299.36 17,248.40 $22,547.76

Bayshore treats the lease as an operating lease. The $20,000 payment will be expensed. Thus, for 2014, Bayshore will report $2,547.76 (22,547.76 - 20,000) more earnings before tax than will Dagger. b.

Total lease related expenses reported by Dagger in 2014 are calculated in a. as $22,547.76. Dagger will deduct 20,000.00 for tax purposes, creating a temporary difference of $2,547.76 - a future deductible amount. The result is a deferred tax asset for 2014 of $1,019.10 ($2,547.76 x 40%). Because Bayshore treats the lease as an operating lease for both tax and accounting purposes, there are no temporary differences and no deferred taxes.

For 2014, Dagger will have no cash flows from operating activities relating to the lease other than the tax shield from the $20,000 lease payment. If the indirect method is employed to report cash flows from operating activities, the interest expense and depreciation expense would be added to net income, and the increase in the deferred tax asset would be subtracted. Bayshore would report a $20,000 operating cash outflow under the direct method of reporting cash flows from operating activities. Because this amount is reported as an expense in the income statement, no adjustment would be needed under the indirect method.

Because Dagger treats the lease as a capital lease, the leased asset is presumed purchased. According to SFAS No. 95 (FASB ASC 230), cash outflows incurred to purchase a productive resource are considered investing activities. Hence, the initial $20,000 payment will be reported as an investing outflow. The amount financed ($66,242) will appear as supplementary information because it represents an investing and financing activity not affecting cash.

201

Because Bayshore treats the lease as an operating lease, the leased asset is not presumed purchased. Hence, the $20,000 initial lease payment is not an investing outflow. Bayshore would report nothing related to the lease as an investing activity. e.

Bayshore will not report any financing activities in 2014 due to the lease. In 2014, Dagger will report the amount of payment which reduces the loan balance ($20,000 $5,299.36) as a financing outflow.

The only cash flow for either company in 2014 is $20,000. Hence, the effect on total cash flows for both companies in 2014 is $20,000.

Reporting the lease as an operating lease has the disadvantage of keeping assets off the balance sheet and the advantage of not reporting the associated liability. An advantage is a smoothed effect on the income statement. Also, less expense is recognized earlier. An adverse effect, is that operating cash flows are lower each year by the difference between the lease payment and any interest payment made. In this case, it also reduces the positive effect of deferred taxes from the balance sheet and income statement. Reporting the lease as a capital lease increases assets. In this case, fixed assets are increased and there is a deferred tax asset. However, the liability must be recognized. Also, expense recognition, net of deferred tax effects, is accelerated in the income statement. At the same time, operating cash flows are improved because they only include payments for interest. Additionally Dagger will report depreciation on the leased asset on its income statement.

Case 13-2 a.

Pippen has a capital lease. Although there is no transfer of ownership, no bargain purchase option, and the lease term is not 75% of the economic life of the asset, the present value of the minimum lease payments is 90% of fair value. Pippen would calculate the present value utilizing a rate of 10%. Under the assumption that the lease payments occur at the beginning of each period, the present value of the minimum lease payments would be $93,649 (10,000 x 9.3649). 90% of fair value would be only $83,363 (92,625 x 90%).

If Grant treats the lease as a capital lease, it would be reported as a sales-type lease. Since the description of the lease does not mention that the residual value is guaranteed, the presumption should be that it is not. Grant's gross investment is $202,750 (10,000 x 20 + 2,750). This amount would be recorded as lease payments receivable and reduced by the initial $10,000 payment to 192,750. The initial net investment is the fair value of the asset, $92,625. The difference between the gross investment and the net investment is unearned income, $110,125. The net investment adjusted for loan payments and interest is reported in the balance sheet at year end. Interest is calculated on the net investment using the effective interest rate of the lessor. For a sales type lease, the effective rate and the implicit rate for the lessor are always the same. Hence, interest revenue of $9,915 (82,625 x 12%) would be recorded. The accompanying debit would be to unearned income. If the residual value is guaranteed, Sales of $92,625 and cost of goods sold of $75,000 would be recognized. 202

If the residual value is not guaranteed, both sales and cost of goods sold would be reduced by the present value of the expected salvage value of $2,750, discounted at 12%. This has no effect on gross profit, the amount reported for the net investment, or the calculation of interest. c.

If the lease is a sales type lease, Grant would not report any depreciation expense for 2014. Income before tax would increase by the amount of gross profit, $17,625 ($92,625-$75,000) and by the amount of interest revenue. If there are initial direct costs, they would be shown as a selling expense. The balance sheet would report the gross investment minus payments received and the remaining unearned income. Because sales are operating activities, the cash inflow of $10,000 would be an operating inflow that would be reported under the direct method of reporting operating cash flows. If the indirect method were used to report cash flows from operating activities, the increase in the net investment (from zero to its yearend balance) would be subtracted from net income.

Grant should report the lease as a sales-type lease because the 90% test is met. Fair value less $2,750 x 0.1037

$92,625 ( 285) $92,340 = 90% x 92,625

In addition, to qualify as a sales type lease, the certainty criteria also must be met. There must be no important uncertainties surrounding the collectability of the receivable or any anticipated future cash outflows of the lessor. If the two certainty criteria are not met, Grant should report the lease as an operating lease. e.

The financial statement impacts of treating the lease as a sales type lease when the salvage value is not guaranteed are discussed above in b.

If Grant treats the lease as an operating lease, lease income of $10,000 will be reported. If there are initial direct costs, 1/20 of those costs will be subtracted from lease income. The balance sheet would report the cost of the leased asset, $75,000 less accumulated depreciation calculated on a straight-line basis over its useful life of 30 years and any unamortized initial direct costs. The statement of cash flows would report an inflow of $10,000 and if there are initial direct costs, their outflow. Both cash flows would appear as operating activities.

Case 13-3 a.

When a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, it should be capitalized by the lessee. The economic effect of such a lease on the lessee is similar, in many respects, to that of an installment purchase. 203

Lani should account for this lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs, together with any profit thereon. However, if the amount so determined exceeds the fair value of the leased machine at the inception of the lease, the amount recorded as the asset and obligation should be the machine's fair value.

Lani will incur interest expense equal to the interest rate used to capitalize the lease at its inception multiplied by the appropriate net carrying value of the liability. In addition, Lani will incur an expense relating to amortization of the capitalized cost of the leased asset. This amortization should be based on the estimated useful life of the leased asset and amortized in a manner consistent with Lani's normal depreciation policy for owned assets.

The asset recorded under the capital lease and the accumulated amortization should be reported on Lani's December 31, 2014, balance sheet classified as noncurrent and should be separately identified by Lani in its balance sheet or footnotes thereto. The related obligation recorded under the capital lease should be reported on Lani's December 31, 2014, balance sheet appropriately classified into current and noncurrent categories and should be separately identified by Lani in its balance sheet.

Case 13-4 a.

Doherty Company has entered into a capital lease if at its inception the lease meets one or more of the following criteria. 1.

The lease transfers ownership of the equipment to Doherty Company by the end of the lease term.

The lease contains a bargain purchase option.

3. The lease term is equal to 75 percent or more of the estimated economic life of the leased equipment. 4. The present value of the minimum lease payments at the beginning of the lease term-excluding that portion of the payments representing executory cost such as insurance, maintenance, and taxes to be paid by Lambert Company, including any profit thereon-equals or exceeds 90 percent of the amount by which the fair value of the equipment leased to Lambert Company at the inception of the lease exceeds any related investment tax credit that the Lambert Company retains and expects to realize. The criteria in items 3 and 4 do not apply if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased equipment, including earlier years of use. b.

Lambert Company has entered into a sales type lease or direct financing lease if at its inception the lease meets one or more of the criteria listed in a., above and in addition meets both of the following criteria: 1. The collectability of the minimum lease payment is reasonably predictable. 204

2. No important uncertainties surround the amount of unreimbursible costs yet to be incurred by the Lambert Company under the lease. c.

In a sales-type lease, manufacturer's or dealer's profit is recognized and represents the excess of the fair value of the leased property over the cost at the inception of the lease. In a direct financing lease, the cost and the fair value of the leased property are the same at the inception of the lease. Thus, the lessor had not manufacturer's or dealer's profit; instead, the lessor has only interest income that will he earned over the life of the lease.

Case 13-5 a.

A lease should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the four criteria established by SFAS 13 for classifying a lease as a capital lease. Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion. Lease K should be classified as a capital lease because the lease contains a bargain purchase option. Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease.

For Lease J. Borman Company should record as a liability at the inception of the lease an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount recorded as a liability should be the fair value. For Lease K, Borman Company should record as a liability at the inception of the lease an amount determined in the same manner as for Lease J. and the payment called for in the bargain purchase option should be included in the minimum lease payments. For Lease L, Borman Company should not record a liability at the inception of the lease.

For Lease J. Borman Company should allocate each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability. For Lease K, Borman Company should allocate each minimum lease payment in the same manner as for Lease J. For Lease L, Borman Company should charge minimum lease (rental) payments to rental expense as they become payable.

Case 13-6 205

Part 1 .a.

A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments during the year would be allocated between a reduction in the obligation and interest expense. Because the lease transfers ownership of the leased asset to the lessee, the asset would be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets. That is, the lessee depreciates the leased asset over its useful life.

No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be used.

Part 2 a.

The gross investment in the lease is the same for both a sales-type and a direct-financing lease. The gross investment in the lease is the minimum lease-payments (net of amounts, if any, included therein for executory costs such as maintenance, taxes, and insurance to be paid by the lessor, together with any profit thereon) plus the unguaranteed residual value accruing to the benefit of the lessor.

For both a sales-type lease and a direct-financing lease, the unearned interest income would be amortized to income over the lease term by use of the interest method to produce a constant periodic rate of return on the net investment in the lease. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method.

In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered manufacturer's or dealer's profit and would be included in income in the period when the lease transaction is recorded. In a direct-financing lease, there is no manufacturer's or dealer's profit. The income on the lease transaction is composed solely of interest.

Case 13-7 a.

.i. Because the present value of the minimum lease payments is greater than 90 percent of the fair value of the asset at the inception of the lease, Milton should record this as a capital lease. ii. Since the given facts state that Milton (lessee) does not have access to information that would enable determination of James (lessor) implicit rate for this lease, Milton should determine the present value of the minimum lease payments using the incremental borrowing rate (10 percent) that Milton would have to pay for a like amount of debt obtained through normal third-party sources (bank or other direct financing). Because the present value is less than 100 percent of fair market value, it should be used as the recorded value of the asset. 206

iii. The amount recorded as an asset on Milton's books should be shown in the fixed assets section of the statement of financial position as "Fixed Assets Acquired Through Lease" or another similar title. Of course, at the same time as the asset is recorded, a corresponding liability ("Obligations Under Capital Leases") is recognized in the same amount. This liability is classified as both current and noncurrent, with the current portion being that amount that will be paid on the principal amount during the next year. The machine acquired by the lease is matched with revenue through depreciation over the life of the lease, since ownership of the machine is not expressly conveyed to Milton in terms of the lease at its inception. The minimum lease payments represent a payment of principal and interest at each payment date. Interest expense is computed at the rate at which the minimum lease payments were discounted and represents a fixed interest rate applied to the declining balance of the debt. Executory costs (such as insurance, maintenance, or taxes) paid by Milton are charged to an appropriate expense, accrual, or deferral account as incurred or paid. iv. For this lease, Milton must disclose the future minimum lease payments in the aggregate and for each of the succeeding fiscal years, with a separate deduction for the total amount for imputed interest necessary to reduce the net minimum lease payments to present value of the liability (as shown on the statement of financial Position). b.

.i. Based upon the given facts, James has entered into a direct financing lease. There is no dealer or manufacturer profit included in the transaction; the discounted present value of the minimum lease payments is in excess of 90 percent of the fair value of the asset at the inception of the lease agreement; collectability of minimum lease payments is reasonably assured; and there are no important uncertainties surrounding unreimbursible costs to be paid by the lessor. ii. James should record the gross amounts of minimum lease payments and the unguaranteed residual value of the machine at the end of the lease as minimum lease payment receivable and remove the machine given up from the books by a credit to the applicable asset account. The balancing amount in this entry is recorded as unearned revenue. iii. During the life of the lease, James will record payments received as a reduction in the receivable. Unearned revenue is recognized as earned interest revenue by applying the implicit interest rate to the declining balance of a gross minimum lease payments receivable reduced by payments received and the balance of unearned revenue. The implicit rate is the rate of interest that, when applied to the gross minimum lease payments (net of executory costs and any profit thereon) and the unguaranteed residual value of the machine at the end of the lease, will discount the sum of the payments and unguaranteed residual value to the fair value of the machine at the date of the lease agreement. This method of earnings recognition is termed the interest method of amortization of unearned revenue. iv. James must make the following disclosures with respect to this lease: a. The components of the net investment in direct financing leases, which are (1) the future minimum lease payments to be received, (2) any unguaranteed residual values accruing to the benefit of the lessor, an (3) the amounts of unearned revenue. b. Future minimum lease payments to be received for each of the remaining fiscal years (not to exceed five) as of the date of the latest statement of financial position presented. 207

Case 13-8 a.

The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent terms, the lease should be capitalized.

A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value.

A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the obligation.

Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain purchase option.

FASB ASC 13-1 Initial Direct Cost Incurred by the Lessor Search Initial direct costs of lessor Topic 840-20-35

FASB ASC 13-2 Interpretations for Lease Accounting Access topic 840 and use the Printer Friendly with sources function.

FASB ASC 13-3 Time Sharing Search time sharing and reversionary 978-840-25 FASB ASC 13-4 Sale and Leasebacks on Rate-Making Use Industry link-Regulated Industries-leases. 980-840

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FASB ASC 13-5 When an Arrangement Qualifies as a Lease Search Arrangement and Lease 840-10-15 FASB ASC 13-6 Lease Fiscal Funding Clause Search Glossary: fiscal funding clause 840-10-25 FASB ASC 13-7 Terminal Space and Airport Facilities Search Terminal Space and Airport Facilities 840-10-25 Room for Debate Debate 13-1 Team 1 Argue for the capitalization of leases which do not meet the SFAS No. 13 criteria for capitalization SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. An asset embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net assets. A lease embodies the transfer of rights to the lessee to use the leased asset. The use of the asset singly, or in combination with other assets contributes directly or indirectly to generate future cash flows. A particular entity can obtain the benefit derived from an asset or control other’s access to it. The lease transfers rights to use the asset to the lessee who then obtains benefits derived from its use. The transaction or event giving rise to the entity’s right to or control of the asset has already occurred. That transaction is the initiation of the lease agreement. It is clear that a lease agreement has all three characteristics of an asset even when it does not meet the SFAS No. 13 criteria for capitalization as an asset. Similarly, the lease obligates the entity to make future cash payments and meets the definition of a liability. Liabilities are defined by SFAC No. 6 as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. They embody a present duty or responsibility to one or more other entities (in this case to the lessor) that entails settlement by probable future transfer or use of assets at a specified determinable date. The lease payments are set and will entail the payment of assets (cash) to the lessor at specified amounts and dates according to the lease contract. Finally, the transaction or event (the initiation of the lease contract) obligating the entity to make the lease payments has already happened.

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Team 2 Argue against the capitalization of leases which do not meet the SFAS No. 13 criteria for capitalization The lease criteria found in SFAS No. 13 are intended to be used to determine whether a lease should be capitalized or not. If they do not meet at least one of the four lease criteria, the transaction does not indicate that a purchase of an asset has occurred or that a liability has been incurred. Instead the lease payments are considered a period expense. If none of the lease criteria are met, then the leased asset will revert to the lessee at the end of the lease term. Title to the asset will never have belonged to the lessee. Hence, the lessee has only temporary use, or control of the asset and does not meet the definition of an asset. Moreover, the lessee will not have acquired substantially all of the economic benefits to be derived from the leased asset because the lessee will not derive benefit for virtually all of its useful life (at least 75% thereof). Nor do the amount and timing of the lease payments imply that the lessee is essentially paying for the asset (present value of minimum lease payments at least 90%). The implication of the agreement is that the lessor owns and controls the asset, but is allowing the lessee to use the asset temporarily for a fee, or rent. If the leased asset does not belong to the lessee then payments for its use are merely periodic rent and as such should be treated as rent expense. As such they do not represent payments on a liability. Thus, it would be inappropriate to record a liability for a lease that is not in essence a purchase of an asset.

Debate 13-2 Lease Accounting Symmetry Team 1 Accounting transparency and the Conceptual Framework requires that a company’s financial statements reflect its assets, liabilities, and owners’ equity as of the balance sheet date as well as its revenues, expenses, gains and losses that occurred over the accounting period. The lessee should classify a lease as an operating lease when it does not meet any of the four capital lease criteria, regardless of the accounting approach taken by the lessor. In other words, the accounting treatment of one company should not dictate the accounting treatment of another, even when accounting for the same transaction. Just because the lessor accounts for a lease as a sales-type lease does not imply that the lessee must report the lease as a capital lease. SFAS No. 13 does not require that both parties to the lease account for it in the same manner. Both parties may not measure items used to determine whether the lease meets any of the four lease criteria in the same way. For example the number of years to useful life from one company’s perspective may differ from that of the other. Just because the lease meets the useful life criterion for the lessor does not imply that it also must be met by the lessee. If not, then the lessee would not have leased the asset for substantially all of its useful life and thus from the lessee’s perspective the lease does not have the characteristics of asset ownership. Similarly, the estimate of the asset’s fair value is not required to be the same for both parties to the lease. Hence, the lessor may believe that the 90% test is met while the lessee may not. Team 2 Accountants should report the economic substance of economic events and transactions. The transaction or event, in this case, is the occurrence of a lease, should dictate its accounting treatment. It is logical that if one company sells an asset to another, the second party must have 210

bought it. The asset in question must be owned by someone – if not the lessor, then it is owned by the lessee. If the lessor determines that the lease is a sales-type lease, then the lease must have met the four capital lease criteria. Those four criteria are intended to determine whether an assets a lease that transfers substantially the entire benefits and risks incident to the ownership of property from the lesssor to the lessee. If so, it should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor. All other leases should be accounted for as operating leases. In a lease that transfers substantially all of the benefits and risks of ownership, the economic effect on the parties is similar, in many respects, to that of an installment purchase. If the lease transfers substantially all of the risks and benefits of ownership from the lessor to the lessee, then when the lessor also meets the certainty criteria and recognizes a manufacturer or dealer’s profit, the lessor has a sales type lease. Similarly, the lessee would have received the risks and benefits of ownership and as a result, cannot have an operating lease. WWW Case 13-9 a. When a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee, it should be capitalized by the lessee. The economic effect of such a lease on the lessee is similar to an installment purchase of an asset. b. Dahlgren should account for this lease at its inception as an asset and an obligation at an amount equal to the present value of the minimum lease payments during the lease term, excluding that portion of the payments representing executory costs or other expenses included in the lease payment. However, if this amount exceeds the fair value of the leased asset at the inception of the lease, the amount recorded as the asset and obligation should be the asset’s fair value. c. Dahlgren will incur interest expense that is calculated by multiplying the interest rate used to capitalize the lease at its inception by the appropriate net carrying value of the liability at the beginning of each period. In addition, Dahlgren will incur an expense relating to depreciation of the capitalized cost of the leased asset. This depreciation charge is based on the estimated useful life of the leased asset and depreciated in a manner consistent with Dahlgren’ normal depreciation policy for owned assets. d. The asset recorded under the capital lease and the accumulated depreciation should be classified on Dahlgren’ December 31, 2014, balance sheet as noncurrent and should be separately identified by Dahlgren in its balance sheet and footnotes. The related obligation recorded under the capital lease should be reported on Dahlgren’ December 31, 2014, balance sheet appropriately classified into current and noncurrent liabilities categories and should be separately identified by Dahlgren in its balance sheet. Case 13-10 a.

The appropriate amount for the leased aircraft on Hill Corporation’s balance sheet after the lease is signed is $10,000,000, the fair value of the plane. Since the fair value is less than the present value of 211

the net rental payments plus purchase option ($10,222,260), the asset is recorded at the fair value of the asset. b.

The leased aircraft will be reflected on Hill Corporation’s December 31, 2014 balance sheet as follows: Noncurrent assets Leased equipment Less: Accumulated depreciation-capital leases

$10,000,000 925,000 $9,075,000

Current liabilities Interest payable Lease liability

$ 776,000 601,800 $ 1,377,800

Noncurrent liabilities Lease liability

$8,020,400

Computations Depreciation expense: Capitalized amount Less: Salvage value

$10,000,000 750,000 $ 9,250,000

Economic life

10 years

Annual depreciation

$925,000

Liability amounts: Lease liability 1/1/14 Less: Payment 1/1/14 Lease liability 12/31/14 Lease payment due 1/1/15 Less: Interest on lease ($862,220 X .09) Reduction of principal Noncurrent liability 12/31/14

$10,000,000 1,377,800 8,622,200 $1,377,800 776,000 601,800 $ 8,020,400

Case 13-11 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case Answers will vary depending on companies selected.

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CHAPTER 14 Case 14-1 a.

i. In a defined contribution plan, the employer promises to contribute a certain sum into the plan each period. For example, the employer may promise to contribute 8 percent of the employee's salary each year. However, no promise is made concerning the ultimate benefits to be paid. Benefits are ultimately determined by the return on the invested pension funds. ii. In a defined benefit plan, the amount of pension benefits to be received in the future is defined by the terms of the plan. For example, the retirement plan of one company promises that an employee retiring at age 65 will receive 2 percent of the average of the highest 5 years' salary for every year of service. Therefore, an employee working for this company for 30 years would receive a pension for life equal to 60 percent of the average of his or her highest 5 salary years. In defined benefit plans, it is necessary for the employer to determine the annual contribution necessary to meet the benefit requirements in the future.

i. A cost approach estimates the total retirement benefits to be paid in the future and then determines the equal annual payment that will be necessary to fund those benefits. The annual payment necessary is adjusted for the amount of interest assumed to be earned by funds contributed to the plan. ii. A benefit approach determines the amount of pension benefits earned by employee service to date and then estimates the present value of those benefits. Two benefit approaches may be used: (1) the accumulated benefit approach and (2) the benefits/years of service approach. The major difference between these two methods is that under the accumulated benefits approach, the annual funding and liability are based on existing salary levels; whereas under the benefits/years of service approach (also called the projected unit credit method) the annual funding and liability are based upon the estimated final pay at retirement. The liability for pension benefits under the accumulated benefits approach is termed the accumulated benefits obligation, whereas the liability computed under the benefits/years of service approach is termed the projected benefit obligation.

Case 14-2 a.

The service cost component is determined as the actuarial present value of the benefits attributed by the pension formula to employee service for that period. This requirement means that one of the benefit approaches discussed earlier must be used as the basis for assigning pension cost to an accounting period. It also means that the benefits/years of service approach should be used to calculate pension cost for all plans that use this benefit approach in calculating earned pension benefits. The FASB's position is that the terms of the agreement should form the basis for recording the expense and obligation, and the plan's benefit formula is the best measure of the amount of cost incurred each period. The discount rate to be used in the calculation of service cost is the rate at which the pension benefits 213

could be settled, such as by purchasing annuity contracts from an insurance company. This rate is termed the settlement-basis discount rate. ii. The interest cost component is determined as the increase in the projected benefit obligation due to the passage of time. Recall that the pension liability is recorded on a discounted basis and accrues interest each year. The interest cost component is determined by accruing interest on the previous year's pension liability at the settlement-basis discount rate. iii. The actual return on plan assets component is the difference between the fair value of these assets from the beginning to the end of the period, adjusted for contributions, benefits and payments. That is, the interest and dividends earned on the funds actually contributed to the pension fund will reduce the amount of net Pension cost for the period. iv. Prior service cost is the total cost of retroactive benefits at the date the pension plan is initiated or amended. Prior service cost is assigned to the expected remaining service period of each employee expected to receive benefits. (As a practical matter, the FASB allows for a simplified method of assigning this cost to future periods; the company may assign this cost on a straight-line basis over the average remaining service life of its active employees.) v. SFAS No. 87 requires significant changes in pension accounting from what was previously required in APB Opinion No. 8. As a result, the board decided to allow for a relatively long transition period. Since these changes are so significant, an unrecognized net obligation or unrecognized net asset will frequently result when changing to the new reporting requirements. Therefore, the provisions of SFAS No. 87 require companies to determine, on the date the provisions of this statement are first applied, the amount of (1) the projected benefit obligation and (2) the amount of the fair value of the plan assets. This will result in either an unrecognized net obligation or unrecognized net asset. This amount, termed the transition amount should be amortized on a straight line basis over the average remaining service period of employees expecting to receive benefits. b.

When a plan is initiated or amended, the increase in prior service cost to be amortized in future periods is not recorded. Recall that the FASB's original position on this issue, expressed in "Preliminary Views," was that a liability existed when the projected benefit obligation exceeded the plan assets or that an asset existed if the reverse was true. Since agreement on this issue could not be reached, the board developed a compromise position which requires recognition of a liability, termed the minimum liability, when the accumulated benefit obligation exceeds the fair value of the plan assets. It is important to note that the minimum liability is based upon the accumulated benefit obligation and not the projected benefit obligation. As a result, future salary levels are not taken into consideration in computing the minimum liability. The debit to offset any recognized minimum liability is not recorded as a component of annual pension cost. This amount is generally recognized as an intangible asset because unfunded accumulated benefits usually result from plan amendments that are expected to benefit future periods. However, in the event the amount of minimum liability exceeds the amount of the existing prior service cost, this excess is not considered to have future economic benefit and must be classified as a reduction of equity instead of an intangible asset. The intangible asset or reduction of equity is not amortized. The required amount of minimum liability is reassessed annually, and any necessary adjustment is made directly to either the intangible asset or stockholders' equity. 214

Case 14-3 a.

The two accounting problems resulting from the nature of the defined benefit pension plan are as follows: *

Estimates or assumptions must be made concerning future events that will determine the amount and timing of the benefit payments.

Some approach to attributing the cost of pension benefits to individual years of service must be selected. The two problems arise because a company must recognize pension costs before it pays pension benefits.

Carson should determine the service cost component of the net pension cost as the actuarial present value of pension benefits attributable to employee services during a particular period based on the application of the pension benefit formula.

Carson should determine the interest cost component of the net pension cost as the increase in the projected benefit obligation due to the passage of time. Measuring the projected benefit obligation requires accrual of an interest cost at an assumed discount rate.

Carson should determine the actual return on plan assets component of the net pension cost as the change in the fair value of plan assets during the period, adjusted for (1) contributions and (2) benefit payments.

Case 14-4 a.

The following characteristics of OPRBs make them different from defined benefit pension plans: 1.

Defined benefit pension payments are determined by formula. Once the employee retires, the amount of future cash outlays per year of retirement is generally fixed. Although actuarial assumptions are made, the measurement of the projected pension obligation is fairly objective. On the other hand, future cash flows for OPRBs is a function of the future costs of services, such as healthcare. Obviously, the present obligation to provide these services is difficult to predict and measure.

Employees accumulate future defined pension benefits with years of service. Employees do not accumulate OPRBs with years of service.

Defined pension benefits vest. This means that employees who have vested benefits may keep the benefits if they leave or seek employment elsewhere. These rights are protected by ERISA. OPRBs do not vest. Employees who leave have no further claim to OPRBs. OPRBs are explicitly excluded from ERISA.

The accounting for OPRBs differs from the accounting for defined benefit pension plans in the following respects:

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1. Accounting for defined benefit pension plans requires recognition of a minimum liability equal to the funded status of the plan wherein the employer's obligation for future benefits earned to date is measured by using the accumulated benefit obligation. Due to measurement problems associated with OPRBs, no minimum liability is required. 2. The pension service cost component is that portion of the PBO attributable to employee service during the current year. The service cost for OPRB is ratably apportioned to employee service lives. 3. OPRB prior service cost is amortized over the life expectancy of employees when most employees are fully eligible to receive benefits, else they are amortized to the date of full eligibility. Defined benefit pension plan prior service cost is amortized over the service lives of employees. 4. Defined benefit pension plan gains and losses are amortized using the corridor approach at a minimum over the service lives of employees as an adjustment to pension expense. OPRB gains are treated as offsets to unrecognized prior service costs and transition obligations. 5. The transition amount for defined benefit pension plans is amortized over the average remaining service lives of employees or the company may elect a longer 15 year period. The OPRB transition amount may be recognized immediately, amortized over the average remaining service lives of employees or over 20 years, if longer. In addition, the cumulative expense recognized as a result of electing to defer recognition of the transition amount may not exceed the cumulative expense that would occur on a pay-as-you-go basis. c.

OPRBs are similar to defined benefit pension plans in the following respects: Management promises OPRBs and defined pension benefits to employees in exchange for current services. The notion that OPRBs and defined pension benefits are both forms of deferred compensation is consistent with theories of labor economics wherein management and labor contract for wages equal to their marginal revenue product. Under this concept employees bargain for total wages and agree to defer wages to retirement years.

The accounting for OPRBs is similar to the accounting for defined benefit pension plans in the following respects: 1. The accounting for both requires that the cost of the future benefits be accrued over the working lives of the employees who will receive them. 2. The interest component for pension expense and OPRBs is calculated based on the value of the beginning employer obligation.

Case 14-5 a.

Projected Benefit Obligation Fair Value of Plan Assets Funded Status

$205 (175) $ 30 underfunded

Penny Pincher’s unsatisfied obligation is $30. This amount is consistent with the definition of liabilities found in SFAC No. 6. SFAC No. 6 defines liabilities as the probable future sacrifice 216

of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. The obligation is contractual. It accrues as the employees perform services. The measurement of the obligation is consistent with the notion that the employees have already earned the future benefits to be paid to them during retirement. The measured amounts of the projected payments takes into consideration the benefit formula and projected salaries that will actually be used to determined the amounts to be paid. The result is a measurement of the expected future cash outflows resulting from prior transactions or events, employees working and earning future benefits. Part of the obligation has already been satisfied (paid for) by placing assets into a fund and foregoing the return on those assets. The remaining obligation is a liability to the company. c.

The FASB ASC 715 guidelines require recognition of the overfunded or underfunded status of a DBPP or OPBP as an asset or liability in a company's statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Therefore, Penny Pincher should report the funded status, underfunded $30, on its balance sheet.

Case 14-6 a.

According to SFAS No. 87, the discount rate used to calculate the projected benefit obligation, the accumulated benefit obligation, vested benefits, service cost, and the interest component on pension expense shall reflect the rates at which the pension benefits could be effectively settled, i.e., the settlement rate. To determine the discount rate, employers are encouraged to look at rates implicit in current annuity contracts that could be used to effectively settle the obligation. They may also look at rates on high-quality fixed income investments.

The FASB chose the settlement rate to discount projected benefits because this rate is consistent with the measurement of the liability owed at the balance sheet date. The resulting present value reflects the amount that it would take to effectively settle the debt (for example by purchasing an annuity contract or a fixed income security) and provide the projected benefits to the employees at retirement.

Other possible discount rates would be the alternative borrowing rate of the employer or the rate of return expected on plan assets. Other liabilities incurred by the corporation are measured using the market rate on the debt when it was incurred. This rate is the rate of interest that the borrower could and did borrow at. Since, the pension obligation is also a liability of the employer corporation, the incremental borrowing rate of that corporation would be a logical selection. The rate of return expected on plan assets is another logical choice. The rates implicit in other liabilities of the corporation is the effective rate, that rate which equates payments to the amount borrowed. Since the pension obligation is being taken care of by payments to a pension fund, the rate earned on funded assets provides payments toward the obligation and is therefore similar to interest payments on a debt. The rate of return is the rate by which the obligation is being settled currently, not the rate by which it could be effectively settled.

Companies believe that investors, creditors and other users use accounting information to make projections of expected future economic performance. These projections include evaluation of the amount, timing and uncertainty of expected future cash flows. Increased volatility would be 217

interpreted an increased uncertainty regarding the amount and timing of future cash flows. Increased uncertainty is associated with increased riskiness. Increased riskiness is associated with lower market values of firm shares. Finance literature teaches us that the higher the risk taken on by the investor, the greater must be the expected return. Greater returns, given expected levels of future cash flows imply smaller investments, i.e., a lower value for the firm. FASB ASC 14-1 Settlement and Curtailment of a Defined Benefit Pension Plan Search pension plan curtailment 715-30-55 The definitions are found in the glossary 715-30-20 FASB ASC 14-2 EITF Interpretations for Pension Accounting Access Defined benefit pension plans. 715-30. Use Printer Friendly with sources to find EITF pronouncements

FASB ASC 14-3 EITF Interpretations for Postretirement Benefits Accounting Search “pensions.” Defined benefit plans-other postretirement 715-60. Use Printer Friendly with sources to find EITF pronouncements FASB ASC 14-4 Discount Rate on Retirement Benefits Search disclosure of assumed discount rate 715-20-55

FASB ASC 14-5 Excess Pension Plan Assets for Contractors Search Excess Pension Plan Assets for Contractors \ 912-715-50 FASB ASC 14-6 Postretirement Health Benefits for Entities in the Coal Industry Use industry link-extractive industries-mining-compensation-retirement benefits 930-715 FASB ASC 14-7 Pension Cost in Regulated Industries 218

Use industry link-regulated industries-compensation-retirement benefits FASB ASC 14-8 Postretirement Benefit Cost in Regulated Industries Use industry link-regulated industries-compensation-retirement benefits Room for Debate Debate 14-1 Articulation of Financial Statements SFAS No. 87( FASB ASC 715) required that projected benefits be used to measure pension expense, but allowed companies to report a minimum liability on the balance sheet using accumulated benefits. The result was that financial statements were not articulated. For the following debate, relate your arguments to the conceptual framework, where appropriate. The articulation of financial statements refers to how they are linked together. That is, in this case the same information is presented regarding pension costs on the income statement and the balance sheet. Team1: Argue in favor of articulation The goal of articulation is to present a cohesive financial picture of an entity such that the relationships between items on the different financial statements are clear. To achieve that goal, assets liabilities, equity revenue, expense, gains and losses should be classified in a consistent manner. Phase B of the joint FASB IASB financial statement project illustrates the current thinking on this issue. Under this proposal, changes in the financial statement elements would be classified consistently in the balance sheet, statement of comprehensive income and the statement of cash flows. These changes are recommended because previously transactions or events recognized in financial statements were not described or classified in the same way in each of the statements. That made it difficult for users to understand how the information in one statement relates to information in the other statements. Team 2 Argue again articulation Although financial statement articulation may be a worthy goal in some situations, in other cases the disclosure of useful information outweighs the advantages of articulation. The disclosure of the minimum pension liability is such a case. This amount is disclosed when the accumulated benefit obligation exceeds the fair value of the plan assets. Thus, even though future salary levels are used to calculate pension expense, the liability reported on the balance sheet need take into consideration only present salary levels. This lack of articulation is due to the contention that the projected benefit obligation overstates the pension liability because it does not represent the legal liability or the most likely settlement amount. Debate 14-2 Measurement of the Pension Obligation SFAS No. 158 no longer allows companies to report the SFAS No. 87 minimum liability in the balance sheet. Instead the amount reported in the balance sheet is measured using projected benefits rather than accumulated benefits. For the following debate, relate your arguments to appropriate accounting theory, including the conceptual framework and capital maintenance 219

theories. Team Debate: Team 1. Argue for the use of projected benefits for pension expense and liability purposes. According to the Conceptual Framework, a company’s financial statements should be articulated. This implies that the measurement of an expense should be based on the same measurement criteria as is the measurement of a related balance sheet item. For example, if a company uses LIFO to value its inventory, then LIFO determines the amount of the company’s cost of goods sold. If a company reports its liability for a defined benefit pension plan measured using accumulated benefits, rather than projected benefits, but reports pension expense measured using projected benefits, its financial statements are no longer articulated. If not, the balance sheet amount cannot be relied upon to help users project the company’s future cash flows (a primary objective of financial reporting). The result of allowing companies to report the minimum liability for defined benefit pension plans was a meaningless amount that was reported as the company’s unamortized prior service cost or a meaningless amount that was reported as an adjustment to accumulated other comprehensive income because companies simply plugged numbers into the balance sheet to make reporting of the minimum liability result in a balance sheet that was in balance. Representational faithfulness, reliability, and relevance require companies to report items in their balance sheet that reflect the items that they purport to represent. A balance sheet plug simply cannot do this. Projected benefits provide a measure of the company’s obligation that employees have earned during the accounting period, but will be paid out in the future. If so, projected benefits provides an appropriate measure of the cost of a pension plan that was incurred during the accounting period and reflected in the income statement as pension expense. By the same token projected benefits provide an appropriate measure of the company’s obligation of those employees. It represents the present value of amounts that will be paid to employees who have already earned those benefits. Since the benefit formula utilizes future salaries to determine what those amounts will be, it follows that it should be used to determine the future cash flows whose present values are reported in today’s financial statements. The current year salaries have been earned, but will not be used to determine what will actually be paid. So they are irrelevant for both income statement and balance sheet measurement purposes. Team 2 Argue for the use of accumulated benefits for pension expense and liability purposes Articulation may provide financial statements whose numbers are interrelated and thus internally consistent, but at the same time, the resulting financial statements may be irrelevant for user decision-making. For example, the use of LIFO to value cost of goods sold may provide an income statement that measures current cost against revenue and thus gives users a good measure of income, but, at the same time the resulting balance sheet inventory amount is totally meaningless because it may include cost that is many years old, and thus in no way reflects its value to the company as an asset. By the same token, use of projected benefits for reporting pension expense may provide relevant amounts for determining income, while the present value of projected benefits may not result in a relevant measure of the company’s liability to employees for a defined benefit pension plan. We argue that the projected benefit obligation overstates a company’s liability for defined benefit pension plans. It includes not only the present value of benefits that will actually be 220

paid, but also the present value of benefits that may never be paid. This is so because it includes estimated benefits for employees who are not yet vested and may leave the company before they are. In these cases the benefits will never be paid. Also, employees may retire at a time that differs from that estimated by the actuary. If so, the measurement of projected benefits is inaccurate. In addition, we believe that accumulated benefits should be used to measure the balance sheet obligation because the accumulated benefit obligation measures the amount that would have to be rolled over today if the company should terminate the defined benefit plan in favor of one that is a type of defined contribution plan or perhaps will no longer offer pension benefits to its employees. Finally, we argue that an economist would say that pension benefits must be related to an employee’s marginal revenue product. The marginal revenue product for this year is not related to future years and so measurement of obligations resulting from its incurrence should not be based on future labor prices. WWW Case 14-7 a.

A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company’s practices. In a contributory pension plan the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost.

The employer is the organization sponsoring the pension plan. The employer incurs the costs and makes contributions to the pension fund. Accounting for the employer involves: (1) allocating the cost of the pension plan to the proper accounting periods, (2) measuring the amount of pension obligation resulting from the plan, and (3) disclosing the status and effects of the plan in the financial statements. The pension fund or plan is the entity which receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the pension recipients. Accounting for the fund involves identifying receipts as contributions from the employer sponsor and as income from fund investments and computing the amounts due to individual pension recipients.

1. Relative to the pension fund the term “funded” refers to the relationship between pension fund assets and the present value of expected future pension benefit payments; thus, the pension fund may be fully funded or underfunded. Relative to the employer, the term “funded” refers to the relationship of the contributions made by the employer to the pension fund and the pension expense accrued by the employer; if the employer contributes annually to the pension fund an amount equal to the pension expense, the employer is fully funded. 2. Relative to the pension fund, the pension liability is an actuarial concept representing an economic liability under the pension plan for future cash payments to retirees. From the 221

viewpoint of the employer, the pension liability is an accounting credit that results from an excess of amounts expensed over amounts contributed (funded) to the pension fund. 1. The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods.

3. Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting if actuarial funding methods are applied to actuarial valuations to determine the provision for pension costs. While cash accounting provides a more precise determination of the final cost, accrual accounting provides a more objective measure of the annual cost. Case 14-8 a.

1. The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods.

b. 2. Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting. c.

Terms and their definitions as they apply to accounting for pensions follow: 1. Market-related asset value, when based on a calculated value, is a moving average of pension plan asset values over a period of time. Considerable flexibility is permitted in computing this amount. In many cases, companies will undoubtedly use the actuarial asset value employed by the actuary as their market-related asset value for purposes of applying this concept to pension reporting. 2.

The projected benefit obligation is the present value of vested and nonvested employee benefits accrued to date based on employees’ future salary levels. This is the pension liability required by GAAP.

3. The corridor approach was developed by the FASB as the method for determining when to amortize the balance in the Accumulated OCI (G/L) account. The net gain or loss balance is amortized when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning-of-the-year balances of the projected benefit obligation or the market-related value of the plan assets. d.

The following disclosures about a company’s pension plans should be made in financial statements or their notes: 222

1. A description of the plan including employee groups covered, type of benefit formula, funding policy, types of assets held, and the nature and effect of significant matters affecting comparability of information for all periods presented. 2. The components of net periodic pension expense for the period. 3. A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period. 4. Pension-related amounts recorded In Accumulated Other Comprehensive Income and the impact of amortization of these items on pension expense in the current and next year. 5. A table indicating the allocation of the pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. In addition, a narrative description of investment policies and strategies, including the target allocation percentages (if used by the company), must be disclosed. 6. The company must disclose the expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter, based on the same assumptions used to measure the company’s benefit obligation at the end of the year. Also required is disclosure of a company’s best estimate of expected contributions to be paid to the plan during the next year. Case 14-9 a.

Pension benefits are part of the compensation received by employees for their services. The actual payment of these benefits is deferred until after retirement. The net periodic pension expense measures this compensation and consists of the following five elements: 1. The service cost component is the present value of the benefits earned by the employees during the current period. 2. Since a pension represents a deferred compensation agreement, a liability is created when the plan is adopted. The interest cost component is the increase in that liability, the projected benefit obligation, due to the passage of time. 3. In order to discharge the pension liability, an employer contributes to a pension fund. The return on the fund assets serves to reduce the interest element of the pension expense. Specifically, the expected return reduces pension expense. Expected return is the expected rate of return times the market-related value of plan assets. 4. When a pension plan is adopted or amended, credit is often given for employee service rendered in prior years. This retroactive credit, or prior service cost, is charged to other comprehensive income (PSC) in the year the plan is adopted or amended, and then is recognized as pension expense over the time that the employees who benefited from this credit worked. 5. The gains and losses component arises from a change in the amount of either the projected benefit obligation or the plan assets. This component is amortized via corridor amortization.

The major similarity between the accumulated benefit obligation and the projected benefit obligation is that they both represent the present value of the benefit attributed by the pension benefit formula to employee service rendered prior to a specific date. All things being equal, when an employee is about to retire, the accumulated benefit obligation and the projected benefit obligation would be the same. The major difference between the accumulated benefit obligation and the projected benefit obligation is that the former is based on present salary levels and the latter is based on estimated 223

future salary levels. Assuming salary increases over time, the projected benefit obligation should be higher than the accumulated benefit obligation. c.

1. Pension gains and losses, sometimes called actuarial gains and losses, result from changes in the value of the projected benefit obligation or the fair value of the plan assets. These changes arise from the deviations between the estimated conditions and the actual experience, and from changes in assumptions. The volatility of these gains and losses may reflect an unavoidable inability to predict compensation levels, length of employee service, mortality, retirement ages, and other relevant events accurately for a period, or several periods. Therefore, fully recognizing the gains or losses on the income statement may result in volatility that does not reflect actual changes in the funded status of the plan in that period. 2. In order to decrease the volatility of the reporting of the pension gains or losses, the FASB had adopted what is referred to as the “corridor approach.” This approach achieves the objective by amortization of the accumulated OCI (G/L) in excess of 10% of the greater of the projected benefit obligation or the market-related asset value of the plan assets.

Case 14-10 The solution to this case is dependant upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions.

Financial Analysis Case Solution will vary depending on the company selected

224

CHAPTER 15

Case 15-1 a.

Under FASB ASC 717-10-25-2, an entity shall recognize the services received in a share-based payment transaction with an employee as services are received. Employee services themselves are not recognized before they are received. The entity shall recognize either a corresponding increase in equity or a liability, depending on whether the instruments granted satisfy the equity or liability classification criteria. As the services are consumed, the entity shall recognize the related cost. For example, as services are consumed, the cost usually is recognized in determining net income of that period, for example, as expenses incurred for employee services. In some circumstances, the cost of services may be initially capitalized as part of the cost to acquire or construct another asset, such as inventory, and later recognized in the income statement when that asset is disposed of or consumed. This Topic refers to recognizing compensation cost rather than compensation expense because any compensation cost that is capitalized as part of the cost to acquire or construct an asset would not be recognized as compensation expense in the income statement. The amount of compensation for compensatory ESOPs is determined on the Grant date. The grant date is the date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory), for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.

.i. John believes that employee stock options are equity securities. His opinion is consistent with prior practice. This position implies that options are nonreciprocal transfers wherein the corporation receives something of value, but gives up nothing in return. Because the option contracts do not obligate the corporation to give up assets or perform future services, they do not meet the definition of liabilities. In addition, their value is derived solely from the underlying market value of the company's stock - i.e., their existence and worth are derived from the value of equity. Because the options exist only to allow the holder to acquire stock, their issue price is similar to a down payment toward the eventual purchase of stock, implying further that the options are equity securities. ii.

Marcy believes that preexisting stockholders are hurt by the exercise of stock options. If so, the option holder is not acting as an owner in the role of owner. Hence, it can be argued that options do not fit the definition of an equity security. Proponents of this view hold that options are debt or quasi-equity. Those who argue that options are liabilities consider the obligation to issue the shares, particularly to the detriment of preexisting shareholders, is a liability. It is argued that the liability could be settled at any time prior to exercise by 225

purchasing the options from the option holder at the then current market price. If so, an appropriate measure of the option's value at the balance sheet date is fair value. If the options are not equity, then changes in fair value would fit the definition of earnings and should be recognized in the income statement. Case 15-2 a.i.

Entity theory income statement: Revenues Cost of goods sold Gross profit Operating expenses Net income

$450,000 220,000 $230,000 64,000 $166,000

Entity theory balance sheet: ASSETS

ii.

EQUITIES

Current assets Noncurrent assets

$ 87,000 186,000

Total assets

_______ $273,000

Current liabilities Bonds payable Preferred stock Common stock PIC in excess of par retained earnings total equities

Proprietary theory income statement: Revenues Cost of goods sold Gross profit Operating expenses Operating income Interest expense Net income

$450,000 220,000 $230,000 64,000 166,000 10,000 $156,000

226

$ 19,000 100,000 20,000 50,000 48,000 36,000 $273,000

Proprietary theory balance sheet:

ASSETS

LIABILITIES

Current assets $ 87,000 Noncurrent assets 186,000

TOTAL ASSETS

$273,000

iii. Residual Equity theory income statement: Revenues Cost of goods sold Gross profit Operating expenses Operating income Interest expense Preferred dividends Net income

Current liabilities Bonds payable Total liabilities Stockholder Equity Preferred stock Common stock

$ 19,000 100,000 $119,000

PIC in excess of par Retained earnings Total SE TOTAL LIAB. & SE

48,000 36,000 $154,000 $273,000

$ 20,000 50,000

$450,000 220,000 $230,000 64,000 166,000 10,000 1,000 $155,000

Residual Equity theory balance sheet: ASSETS Current assets Noncurrent assets

TOTAL ASSETS b.

LIABILITIES $ 87,000 186,000

_______ $273,000

Current liabilities Bonds payable Total liabilities Preferred stock Residual equity Common stock PIC in excess of par Retained earnings Total SE TOTAL LIAB. & SE

$ 19,000 100,000 $119,000 $ 20,000 50,000 48,000 36,000 $134,000 $273,000

Entity theory. There would be no entity theory debt to equity ratio. Entity theory views all equities as contributors of capital. The theory makes no distinction between debt and equity securities. Proprietary theory debt to equity ratio = 119/154 = 0.77 Residual equity theory debt to equity ratio = 121/154 = 0.79

Case 15-3 227

Under the cost method, treasury stock is debited for the purchase price of the shares even though the purchase price is less than par value. Under the par method, treasury stock is debited for the par value of the shares, and a separate paid-in capital account is credited for the excess of the purchase price over the par value.

Under the cost method, treasury stock is debited for the purchase price of the shares. Under the par value method, treasury stock is debited for the par value of the shares, and the debit for the excess of the purchase price over the par value is assigned to additional paid-in capital arising from past transactions in the same class of stock and/or retained earnings.

Under the cost method, treasury stock is credited for the original cost (purchase price) of the shares, and the excess of the original cost (purchase price) over the sales price first is debited to additional paid-in capital from earlier sales or retirements of treasury stock, and any remainder then is debited to retained earnings. Under the par value method, treasury stock is credited for the par value of the shares, and the excess of the sales price over the par value is credited to additional paid-in capital from sale of treasury stock.

Under the cost method, treasury stock is credited for the original cost (purchase price) of the shares and the excess of the sales price over the original cost (purchase price) is credited to additional paid-in capital from sales of treasury stock. Under the par value method, treasury stock is credited for the par value of the shares and the excess of the sales price over the par value is credited to additional Paid-in capital from sale of treasury stock.

There is no effect on net income as a result of treasury stock transactions.

Case 15-4 The steps involved in a quasi-reorganization are: 1. Assets are written down to their fair market value against retained earnings or additional paid-in capital. 2. The retained earnings deficit is eliminated against additional paid-in capital or legal capital. 3. The zero retained earnings balance is dated and this date is retained until it loses its significance (typically 5 to 10 years). Carrol, Inc. should prepare the following journal entries to accomplish the quasi-reorganization. Additional paid-in capital $ 100,000 Retained Earnings 1,100,000 Equipment $1,200,000 Common Stock

2,000,000 Retained Earnings 228

2,000,000

Carrot, Inc. should also date the retained earnings balance December 31, 2014 until the date loses its significance. Case 15-5 a.

The five methods that were proposed to determine the value of a stock option prior to the release of SFAS No. 123R involved determining the excess of the fair value of the stock over the option price at one of the following dates: i. The date of the option grant. ii. The date the option becomes the property of the employee. iii. The date the option is first exercisable. iv. The date the option is exercised. v. The date of exercise, adjusted for the income tax effect to the corporation.

The conceptual merits of the methods are: .i. The excess of the fair value of the stock over the option price at the date of the option grant is the generally accepted method of valuation. The lack of a ready market value for the options does not negate the existence of their value. The excess of the fair value of the stock over the option price is usually easily measurable (the more closely held the stock, the more difficult the measurement). The value at the grant date is appropriate because this is the point at which the corporation forgoes the alternative uses of the optioned shares, and any difference between option price and market price of the shares or the value of the option after that date only benefits the option holder in his role as a potential investor, not in his role as an employee contracting for services. ii. The date the option becomes the property of the employee (i.e., the date the employee fulfills any conditions included in the option plan) is appropriate because it is at this time that the corporation has an unqualified obligation. iii.The date the option is first exercisable is appropriate because it is at this date that the employee first has control over the option and only from this date that he can be considered as an investor. iv. The date the option is exercised is appropriate because it is only at this date that it is certain that exercise will occur; prior to exercise, the corporation has only a contingent obligation. v. Adjustment for the income tax effect to the corporation is justifiable in the case of nondeductible stock options. Had the firm chosen to compensate the employee with an additional (deductible) cash payment, the firm's income tax would have been less. Thus the total cost of the option to the firm includes the difference in tax.

Case 15-6 a.

Under FASB ASC 718-10-50, the required financial statement disclosure at December 31, 2014 includes sufficient information that enables users of the financial statements to understand all of the following: 229

a. The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders b. The effect of compensation cost arising from share-based payment arrangements on the income statement c. The method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant), during the period d. The cash flow effects resulting from share-based payment arrangements. This disclosure is not required for interim reporting.. The following list indicates the minimum information needed to achieve the objectives in the preceding paragraph and illustrates how the disclosure requirements might be satisfied. In some circumstances, an entity may need to disclose information beyond the following to achieve the disclosure objectives: a. A description of the share-based payment arrangement(s), including the general terms of awards under the arrangement(s), such as: 1. The requisite service period(s) and any other substantive conditions (including those related to vesting) 2. The maximum contractual term of equity (or liability) share options or similar instruments 3. The number of shares authorized for awards of equity share options or other equity instruments. b. The method it uses for measuring compensation cost from share-based payment arrangements with employees. c. For the most recent year for which an income statement is provided, both of the following: 1. The number and weighted-average exercise prices (or conversion ratios) for each of the following groups of share options (or share units): i. Those outstanding at the beginning of the year ii. Those outstanding at the end of the year iii. Those exercisable or convertible at the end of the year iv. Those that during the year were: 01. Granted 02. Exercised or converted 03. Forfeited 230

04. Expired. 2. The number and weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured pursuant to paragraph 718-10-30-21) of equity instruments not specified in (c)(1), for all of the following groups of equity instruments: i. Those nonvested at the beginning of the year ii. Those nonvested at the end of the year iii. Those that during the year were: 01. Granted 02. Vested 03. Forfeited. d. For each year for which an income statement is provided, both of the following: 1. The weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured at that value pursuant to paragraphs 718-10-30-21 through 30-22) of equity options or other equity instruments granted during the year 2. The total intrinsic value of options exercised (or share units converted), share-based liabilities paid, and the total fair value of shares vested during the year. e. For fully vested share options (or share units) and share options expected to vest at the date of the latest statement of financial position, both of the following: 1. The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) outstanding 2. The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) currently exercisable (or convertible). 3. b.

At December 31, 2015, a footnote to the financial statements should also describe the status of the plan and state that all options have been exercised at the option price given.

A dilution of the existing stockholders' equity could occur when the optioned shares are issued only if it could be demonstrated that there was no value in the option holder’s' incentive services exchanged for the option grant. The dilution could occur also if the optionee left the corporation after exercise of the option but prior to the termination of the contract period. If the value of the incentive services was to cover the five years of this contract and an optionee left at the end of four years, the 231

compensation cost for the fifth year of this contract should be shown as a loss arising from the option grant. Dilution, as typically determined by the financial analyst, would be considered to have occurred if per-share earnings and/or book value decreased. ii. To the extent that the optionee's incentive services invested under the option grant are equal to the implicit value of the option contract, there has been a fair exchange of values and there would be no dilution of the stockholders' equity. Case 15-7 a.

Under the proprietary theory, the accounting concepts are defined from the viewpoint of the proprietor. Assets are looked upon as the property of the proprietor and liabilities the debts of the proprietor. Under the entity theory, the firm is looked upon as separate and distinct from its owners. The creditors and owners alike are interested in the welfare and success of the firm. Income and expenses are defined from the point of view of the firm. In the funds theory, the balance sheet is comprised of assets on the one side and restrictions of assets on the other side. The area of interest may be limited to a group of assets or a specific set of activities or it may be applied to an entire organization. The fund theory does not have at its center the concept of income but rather the flow of assets and the changes in the restrictions of their use.

The applications of any one of these theories to specific situations depend upon the emphasis desired. However, the usual emphasis suggests the following: i.

The position of the owner in a single proprietorship with respect to income and personal liability for creditors suggests the emphasis of the proprietary theory even though the business is considered separate from the owner's personal affairs.

ii. The partnership equities may be defined in terms of either the proprietary or entity concept depending upon the emphasis desired. As opposed to the single proprietorship, the partnership is considered more of a separate entity. The partnership property is owned by the partnership not by the partners. The partnership creditors must look first to the assets of the partnership. Only if partnership assets are insufficient, may they claim the personal assets of the partners and then only after personal creditors have been completely satisfied. iii. The financial corporation has responsibilities far beyond those to the owners. Very often, depositors and creditors have a greater interest than do the legal owners. Therefore, the emphasis should be in favor of the entity theory. iv. The proprietary theory is often present in consolidated statements because the assets and liabilities of subsidiaries are combined with those of the parent. Consolidated statements can be considered from the point of view of the entity because of the separate concept of the economic unit. It is also possible, but rather remote, to look at the consolidation from the viewpoint of the funds concept as there is no legal relationship between the creditors, parent stockholders, and minority interest and the consolidated assets. The funds concept is reasonable from the economic activity approach to consolidations. 232

v. Estate accounting is usually viewed definitely from the funds approach. The objective of reporting is generally for accountability and information regarding restrictions against assets. Case 15-8 a.

Contributed (or "paid-in") capital is the total amount designated as the permanent capital of a corporation, including amounts paid in for shares, contributed, or capitalized by order of the Board of Directors.

ii. Retained earnings represent the cumulative amount of undistributed income that has not been designated as permanent capital by the Board of Directors. a. Appropriated retained earnings are the amounts of retained earnings that have been restricted by contract and/or by the Board of Directors and are therefore not available as a basis for dividends. b. Unappropriated retained earnings in the amount of undistributed earnings that is available for distribution to stockholders upon appropriate action of the Board of Directors. iii. Unrealized appraisal increments are amounts of upward revaluations of net assets that have not been realized, in accordance with the accounting concept of realization. iv. Cost of treasury shares (contra-amount) is the cost to the corporation of acquiring shares of its own capital stock that are being held in the treasury, and have not been legally canceled or reissued. This amount is subtracted from Stockholders’ equity. v. Minority interest in subsidiaries consolidated. Consolidated statements prepared in accordance with the "entity" theory would include the minority interest in subsidiaries consolidated as a part of the stockholders' equity section. vi. Some companies consider the excess of the book value of the net assets of a subsidiary over the cost thereof to be a part of "capital" surplus. b.

The stockholders' equity section is subdivided in order to give useful information about the source and ownership of corporate net capital, and to indicate any restrictions on its withdrawal. Distinctions between contributed (paid-in) capital and retained earnings indicate the extent to which a company has financed its growth internally. Further distinction in the contributed capital section indicate the relative interests of various classes of owners (e.g., preferred and common). Other classifications are pertinent in determining the unavailability, for reasons of law or management action, of capital for dividend purposes. These include the distinction between legal or stated capital and amounts in excess thereof, treasury stock restrictions, and sometimes appraisal increments, as well as contractual or voluntary appropriations of retained earnings.

Four sources of capital in excess of par or stated value of shares: 1.

Issuance of shares for a consideration in excess of par or stated value per share. 233

Issuance of shares as a stock dividend, where the amount to be capitalized per share exceeds its par or stated value.

Re-issuance of treasury shares for an amount in excess of the cost incurred in reacquiring them.

In ordinary usage the term surplus is used to designate the amount of anything that is in excess of use or need. The amount of capital paid in, in excess of par or stated value, and the income retained in a business are in no sense in excess of amounts that are needed or used by the corporation. Therefore, the terms "capital surplus" and "earned surplus" are likely to be misinterpreted by many users of financial information, and should be avoided whenever possible. Suggested substitutes are "Contributed capital in excess of par or stated value" and "Accumulated earnings retained in the business" or "Retained earnings."

Case 15-9 a.

A stock dividend is the issuance by a corporation of its own stock to its stockholders on a pro rated basis without receiving payment thereof. The stock dividend results in an increase in the amount of the legal or stated capital of the enterprise. The dividend may be charged to retained earnings or to any other capital account that is not a part of legal capital. 1.

From the legal standpoint a stock split-up is distinguished from a stock dividend in that a split-up results in an increase in the number of shares outstanding and a corresponding decrease in the par or stated value per share whereas a stock dividend, though it results in an increase in the number of shares outstanding, does not result in a decrease in the par value of the shares.

From the accounting standpoint the distinction between a stock dividend and a stock splitup is dependent upon the intent of the board of directors in making the declaration. If the intent is to give to stockholders some separate evidence of a part of their prorated interests in accumulated corporate earnings, the action results in a stock split-up, regardless of the form it may take. In other words, if the action takes the form of a stock dividend but reduces the market price markedly, it should be considered a stock split-up. Such reduction will seldom occur unless the number of shares issued is at least 20% or 25% of the number previously outstanding.

The usual reason for issuing a stock dividend is to give the stockholders something on a dividend date and yet conserve working capital. A stock dividend that is charged to retained earnings reduces the total accumulated earnings, and all stock dividends reduce the per share earnings. Issuing a stock dividend to achieve these ends would be a public relations gesture in that the public would be less likely to criticize the corporation for high profits or undue retention of earnings. A stock dividend also may be issued for the purpose of obtaining a wider distribution of the stock. Although this is the main consideration in a stock split-up, it may be a secondary consideration in the issuance of a stock dividend. The issuance of a series of stock dividends will accomplish the same objective as a stock split-up.

234

A stock split-up is intended to obtain wider distribution and improved marketability of shares by means of a reduction in the market value of the company's shares. c.

The amount of retained earnings to be capitalized in connection with a stock dividend (in the accounting sense) might be (1) the legal minimum (usually par or stated value), (2) the average paid-in capital per outstanding share, or (3) the market value of the shares. The third basis is generally recommended on the grounds that recipients tend to regard the market value of the stock received as a dividend as the amount of earnings distributed to them. If the corporation in such cases does not capitalize an amount equal to the fair value of the shares distributed as a dividend, there is left in the corporation's retained earnings account an amount of earnings that the stockholders believe has been distributed to them. This amount would be subject to further stock dividends or to cash dividends. The recipients might thus be misled into believing that the company's distribution-and earnings-are greater than they actually are. If the per share market value of the stock is materially reduced as a result of a distribution, no matter what form the distribution takes, the action is a stock split-up and should be so designated and treated to the extent permitted by legal requirements.

Case 15-10 a.

A stock split effected in the form of a dividend is a distribution of corporate stock to present stockholders in proportion to each stockholder's current holdings and can be expected to cause a material decrease in the market value per share of the stock. Account Research Bulletin No. 43 specifies that a distribution in excess of 20% to 25% of the number of shares previously outstanding would cause a material decrease in the market value. This is a characteristic of a stock split as opposed to a stock dividend, but, for legal reasons, the term "dividends" must be used for this distribution. From an accounting viewpoint, it should be disclosed as a stock split effected in the form of a dividend because it meets the accounting definition of a stock split as explained above.

The stock split effected in the form of a dividend differs from an ordinary stock dividend in the amount of other paid-in capital or retained earnings to be capitalized. An ordinary stock dividend involves capitalizing (charging) retained earnings equal to the market value of the stock distributed. A stock split effected in the form of a dividend involves no charge to retained earnings or other paid-in capital if the par (stated) value of the stock is reduced in inverse proportion to the distribution of stock, other paid-in capital or retained earnings would be charged for the par (stated) value of the additional shares issued. Another distinction between a stock dividend and a stock split is that a stock dividend usually involves distributing additional shares of the same class of stock with the same par or stated value. A stock split usually involves distributing additional shares of the same class of stock but with a proportionate reduction in par or stated value. The aggregate par or stated value would then be the same before and after the stock split.

A declared but unissued stock dividend should be classified as part of corporate capital rather than as a liability in a statement of financial position. A stock dividend affects only capital accounts; that is, retained earnings are decreased and contributed capital is increased. Thus, there is no debt to be paid, and consequently, there is no severance of corporate assets when a stock dividend is issued. Furthermore, stock dividends declared can be revoked by a corporation's board of directors any time prior to issuance. Finally, the corporation usually will formally 235

announce its intent to issue a specific number of additional shares, and these shares must be reserved for this purpose. Case 15-11 a.

Under the provisions of APB Opinion No. 25, Growth company would first calculate the amount of total compensation and then allocate it over the service period. Total compensation = (market price – option price) x number of options. Since the market price and the option price are the same, there would be no compensation. Therefore no expense would be recognized in the income statement for these options.

In this example, the consequence is that the plan is considered compensatory because it is not available to all employees, but no compensation expense is recognized. As a result, there is no direct impact on the company’s financial statements. Nothing is reported in the balance sheet or the income statement for these options even though they clearly have a market value. Since nothing is reported in the financial statements, the granting of these options has no impact on the financial ratios either. In this example, the consequence is that the plan is considered compensatory because it is not available to all employees, but no compensation expense is recognized. As a result, there is no direct impact on the company’s financial statements. Nothing is reported in the balance sheet or the income statement for these options even though they clearly have a market value. Since nothing is reported in the financial statements, the granting of these options has no impact on the financial ratios either. One could argue that the fair value should be reported as an expense. Since it is not, net income is overstated, retained earnings are overstated, and paid-in capital is understated. Thus, any financial ratios that use net income in the numerator would be overstated. According to the conceptual framework, an expense is the outflow of resources or incurrence of a liability for performing activities that constitute the company’s major or central operations. The company has not given up any resources to incur an expense. Nor, has the company incurred an obligation to expend resources or to perform future services. Moreover, because the option price is equal to the market price on the grant date, we can argue that the company hasn’t given the employees anything. The employee will only gain something from the options if the market price rises above the option price. This is speculative in nature and as such could be construed as a violation of the historical cost principle. A potential ethical consideration is that use of the fair value approach rather than APB Opinion No. 25 would cause companies to limit or no longer offer stock option plans to its employees. If so, employees might leave the company.

Under FASB ASC 718-10. The fair value of the options would be used to determine total compensation expense. Total compensation expense would be $3,000 ($3 x 1,000 options). The $3,000 would be spread over the service period – normally from the grant date until the first date that the employees can exercise their options. Each year, paid-in-capital in increased for the amount of the expense that is recognized.

Fair value accounting for employee stock options is consistent with the conceptual framework’s definition of expense because we are giving the employee something of value – the fair value of the options. Although we are not giving the employees an asset, nor are we incurring an obligation that meets the definition of a liability, we are in essence paying for the expense by 236

giving the employees the potential to increase their ownership in the company at potentially a bargain price. We argue that the reduction in price is a cost the company because the stock could be sold to someone on the outside at a higher price. Because fair value accounting for employee stock options properly recognizes an expense equal to the fair value of the options granted to the employees, we always recognize an expense which is consistent with the qualitative characteristic of representational faithfulness. Moreover the financial statements are not biased because the selection of the option price does not affect whether an expense is recognized or not. Thus, fair value accounting should be considered ethical. Case 15-12 a.

The entity theory was proposed in 1922 by Paton who stated that the accounting equation is properly depicted as Assets = Equities. According to Paton, creditors and stockholders provide capital for which they are compensated (with interest or dividends). The source of capital has no effect on how the moneys are spent. That is, whether debt or equity is used as a source of financing, the investment of the capital so derived does not depend on the where the financing came from. If debt is substituted for equity, or vice versa, the cost of the factors of production remains unchanged. Thus, the source of capital has no effect upon and is independent of investment and operations, and the question of debt versus equity is irrelevant. Under entity theory, the debt and equity securities of the company would be arrayed on the right hand side of the balance sheet. Since there is no need for a distinction between debt and equity, none would be made, and there would be no subtotal for debt or equity.

Entity theory is consistent with early theories of finance, e.g., Modigliani and Miller, 1958, however, it is inconsistent with the more recent literature. Debt versus equity was shown to be relevant because the tax deductibility of interest made debt more attractive than equity. Also, there is evidence that when equity related tax shields, such as the investment credit, are removed, debt tax shields are substituted and vice versa, causing changes in the debt-to-equity ratio. In addition there is empirical support for the notion that companies have target debt-toequity ratios and that risk as perceived by the ratio of debt-to-equity makes a difference in the pricing of securities. Finally, it has been demonstrated that complex financial instruments affect firm value and that a complex capital structure has value. To summarize, recent studies in the finance literature indicate that debt versus equity does make a difference and hence the distinction between debt and equity in the balance sheet should continue.

Case 15-13 a.

Convertible debt is a complex hybrid security because it bears an option for the holder to either convert the debt to common stock or redeem it for cash. That is, the holder must either convert the debt to common stock and thus forgo the right to redemption, or redeem the debt for cash and thus forgo the right to convert the debt to common shares. Other complexities occur when the debt instrument has a contingently adjustable conversion ratio or detachable call options. The response to this case will not address these types of complications. The entity may issue convertible debt with a beneficial conversion feature. This occurs when the debt is convertible into common stock at the lower of a conversions that is fixed at the commitment date or a fixed discount to the market price of the common stock at the date of conversion. Thus a beneficial conversion feature exists when the debt instrument is issued at a 237

price such that is below the fair value of the stock into which it is convertible. Stated differently, the conversion price is “in the money” and the holder benefits to the extent of the price difference. Thus, the convertible has what is known as an embedded beneficial conversion feature. ASC 470-20-25-5 requires that when an embedded beneficial conversion feature is present in convertible debt, at issuance the issue shall first allocate a portion of the proceeds that is equal to the n intrinsic value of the conversion feature to additional paid-in-capital. The remainder of the proceeds shall be considered the issue price of the debt itself. \ To illustrate, assume that $1,000,000, 8%, 30 year bonds are issued at 98. Each $1,000 bond is convertible into 40 shares of common stock that has a current fair value of $30 per share. The number of shares that holders could receive upon conversion = 40 x $1,000,000/$1,000 = 40,000 shares. The current market value of the 40,000 shares is $30 x 40,000 = 1,200,000. If we divide the $1,000,000 bon by 40,000 shares, we get only $35 per share. Thus the intrinsic value of the option is $5 per share. Thus, when recording the issuance of the bond, the company would credit additional paid-in capital for $5 x 40,000 = $200,000. The result would be a $200,000 increase in the discount recorded for the bond. The journal entry would appear as follows: Cash 980,000 Discount on Bond s 220,000 Bond Payable Additional Paid-In-Capital

1,000,000 200,000

The more typical case for issuances of convertible debt is to issue debt that has no beneficial conversion feature. Thus, there is no immediate advantage to the holder because the bond is not “in-the-money”. This case is often referred to instead as “plain vanilla”, and there is no intrinsic value to take into consideration. As a result, the debt is recorded as a straight issuance of debt. If the market value of the stock at the date of issuance in the above example was at least $35, there would be no beneficial conversion feature and the issuance would be recorded as follows. Cash Discount on Bond S Bonds Payable

980,000 20,000 1,000,000

FASB ASC 15-1 Cost to Issue Equity Securities to Effect a Business Combination Search business combinations and acquisition costs. 805-10-25 FASB ASC 15-2 Treasury Stock Search treasury stock 238

505-30-45 FASB ASC 15-3 Quasi-Reorganizations Search quasi-reorganizations 855-20 FASB ASC 15-4 Dividends in Arrears Search cumulative preferred dividends 440-10-50 FASB ASC 15-5 Stock Dividends and Splits Search stock dividends and splits 505-20 . FASB ASC 15-6 Treasury Stock Search treasury stock 505-30 FASB ASC 15-7 Mandatorily Redeemable Preferred Stock Search mandatorily redeemable preferred stock 480-10 Definition in glossary 480-10-20 Room for Debate Debate 15-1 Team 1

Argue for current GAAP treatment for the issuance and subsequent reporting of options and warrants Stock options and warrants give the holder the right to purchase a share of stock at a predetermined price within a given time period. Current accounting practice (GAAP) is to report the cash inflow received from these securities as equity. The value reported in subsequent 239

periods is historical and does not change in response to changes in the market value of these securities. To defend this position, we must address two issues: measurement and the appropriateness of displaying the security in the balance sheet as the financial statement element, equity. SFAC No. 6 defines equity as the residual interest in the assets of an entity that remains after deducting its liabilities. If options and warrants do not meet the definition of liabilities, then in the current accounting model (and consistent with this definition of equity) they must meet the definition of equity. A liability is an obligation that embodies a future sacrifice of assets. The company owes no assets to option or warrant holders. There is no present obligation to surrender assets or perform services. Hence, stock options and warrants do not meet the definition of liabilities, and they must be equities. Treating stock options and warrants as equity implies that the holder is acting as an owner. Owner transactions involve nonreciprocal transfers of assets to and from the company where one party the investor gives up something and receives nothing in return; investments by owners and distributions to owners are nonreciprocal transfers. They do not involve revenue or expense. The definition of equity implies that the exercise of an option or warrant involves a nonreciprocal transfer wherein the issuing company receives something of value (e.g., employee services or the fair value of a warrant on the date it was issued), but gives up nothing of value in return. Therefore, financial option contracts that do not result in the eventual payment of assets or the performance of services do not qualify as liabilities, rather they are consistent with the definition of equities. The measurement of equity is historical in nature. Equity purports to represent the amount of moneys that have been contributed to the entity from owners plus the accumulated changes in net assets that have not been distributed to owners. The practice is consistent with the historical cost principal and the stewardship role of accounting. As such, it is consistent with the financial capital maintenance concept of measuring net assets and income. Although the holders of options and warrants are not owners until they exercise their rights, they are not creditors. Moreover, the price paid to acquire stock warrants is a function of the market price of shares of stock. Hence, the value recorded is related to and derived from equity in the company. Team 2

Argue for reporting options and warrants as liabilities measured at fair value Stock options and warrants are acquired and held because of their potential to be exercised so that the holder can acquire shares of stock at a price more favorable than buying the stock in the market. Although the market value of these securities is a function of the market price of shares, the holders are not owners and do not act as owners. They have no residual claim to the net assets of the company. If the company were to liquidate, they would receive no distribution of assets. They have no voting rights. They have no rights to share in the profits of the company, and they have no preemptive right. Moreover, if and when their rights are finally exercised, there is an opportunity loss to existing shareholders because not only is their share of the company and company profits diluted, but also their net assets per share decrease because the option price is less than what the company would have receive had the shares been sold in the market instead. That is, option holders profit at the expense of preexisting stockholders, and thus are not acting in the role of owners. The resulting opportunity loss is financed by diluting preexisting stockholders’ wealth. 240

The foregoing arguments imply that stock options and warrants are not equity. Rather, they are more like liabilities. They represent present obligations to issue stock contingent upon exercise by the holder. Exercise results in a loss to preexisting shareholders. The options and warrants give the holder the right to exchange financial instruments on specified terms. The shares issued represent compensation for the cash received. Because the shares could have been sold at market value, they are issued to the option holder in lieu of cash. Hence, the receipt of cash upon exercise is not a nonreciprocal transfer as would be the case for transactions with owners acting as owners. The obligation to make the exchange embodied in a stock option or warrant may be satisfied at any time prior to exercise by purchasing them in the market at fair value. Because financial option contracts entail contractual obligations of the issuing corporation to deliver financial instruments upon exercise on potentially unfavorable terms to preexisting stockholders, they are more like debt than equity. According to economic theory, income is the change in wealth from one period to the next, excluding investments and distributions to owners. Hence, wealth at a point in time provides a relevant measure of the value of the firm. Fair value is what an asset is worth today in the market. It measures what could be realized from its sale or what it would take to replace the operating assets it has. The fair value of net assets comprises value the stockholder’s claim to the enterprise. This implies that if the fair value of net assets equals stockholder wealth, and as such assets are measured at fair value, then liabilities should also be measured at fair value. Since, as stated above the obligation to issue shares upon exercise of stock warrants can be satisfied by purchasing the warrants in the market, the appropriate measure for predictive purposes is fair value. Debate 15-2 The Nature of Cumulative Preferred Dividends Under GAAP, cumulative preferred dividends are reported as liabilities only after they have been declared by the corporation’s board of directors. For the following debate, support your arguments by referring to the SFAC No. 6 definition of liabilities and the consequent characteristics of liabilities. Team Debate: Team 1: Argue that cumulative preferred dividends are liabilities, even if not declared. The conceptual framework defines liabilities as probable future sacrifices of economic benefits of an entity that result from prior transactions or events. Cumulative preferred dividends meet this definition because they meet the three characteristics of a liability. The first characteristic of a liability is that a liability obligates the entity to give up resources or perform services. Cumulative preferred dividends that have not been paid, will be paid even though they have not yet been declared. The only exception is bankruptcy and dissolution where the company is insolvent. Since we assume a going concern, it makes no sense to presume bankruptcy or dissolution. In other words, unless there is evidence to the contrary, we should presume a probable future outflow regardless of when it will occur. Even if a company liquidates, it must pay the current dividend and any arrearage to preferred stockholders before common stockholders can receive anything. If the company were to buy preferred shares from stockholders, it would be required to pay current and dividend arrearages to the preferred stockholders in addition to paying the investors for the stock itself. 241

The second characteristic of a liability is that it obligates a particular entity. The company is that particular entity. The contract between it and the investor obligates it to pay the dividend, eventually, if not today. The third characteristic of a liability is that it results from a transaction or event. In this case the sale of the preferred stock to investors can be seen as the transaction or event that results in the obligation to pay the dividend. Even though the company may not declare a dividend this year, it will still have to pay the dividend to the preferred stockholder in the event of stock repurchase or liquidation of the company (assuming solvency). Consistent with the accounting rules for contingent liabilities, when an obligation is probable and we can reasonably estimate its amount, it should be reported in a company’s balance sheet. For cumulative preferred dividends, we have made a strong case for probability and no one can dispute the certainty regarding the amount. We know by the contract between the company and its preferred stockholders what the amount is. Team 2: Argue that cumulative preferred dividends are not liabilities, unless they are declared. We agree that the company will eventually have to pay a dividend to a preferred stockholder, provided that it repurchases the stock or terminates business and is solvent. However, the typical underlying accounting assumption is that the company is considered a going concern and is not likely to terminate. In this case, it may be able to put off paying a dividend for a very long time or perhaps even an indefinite period. So, accountants correctly do not report dividends in arrears as liabilities unless they have been declared. A company does not have a legal obligation to pay a dividend unless declared (or in the case of cumulative preferred dividends, when they are declared or when a company terminates or reacquires the preferred shares). Declaration constitutes the critical event that triggers the incurrence of the liability for cumulative preferred dividends or any other dividends. Without declaration there is no liability. Debate 15-3 Distinguishing Between Debt and Equity In its 1990 discussion memorandum on distinguishing between liabilities and equity, the FASB posed the question, “Should the sharp distinction between liabilities and equity be effectively eliminated?” To do so would be consistent with the entity theory of equity and with the notion that the capital structure (debt vs. equity) of a firm is irrelevant to users of financial information. Team 1:

Argue for elimination of the distinction between debt and equity. Support your argument by citing the entity theory of equity as well as finance theory that asserts that capital structure is irrelevant.

We believe that the current distinction between debt and equity in corporate balance sheets should be eliminated. Our position is supported by entity theory which provides a better basis to account for the financial position and operations of the corporation than does the proprietary theory. A corporation is characterized by the separation of ownership and management. Its legal definition treats the corporation as though it were a person – a separate legal entity, separate from its owners, the stockholders. We argue that entity theory provides the appropriate foundation to represent the financial position of the corporate form. From an accounting standpoint, the entity theory can be expressed as 242

assets = equities The entity theory is a point of view toward the firm and the people concerned with its operation. This viewpoint places the firm, and not the owners, at the center of interest for accounting and financial reporting purposes. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups. Unlike a partnership or a sole proprietorship, the owners’ risk of loss is limited to their investment in the firm. If the company goes bankrupt, they are not obligated for debts of the firm. Thus, the corporate concept of limited liability makes the proprietary unsuitable for the corporate form of business. Limited liability enables stockholders to have the same sort of risk that is associated with debt. Even though the creditor has priority over the stockholder in the case of corporate liquidations, like the stockholder, the creditor can lose his investment and the interest income stream from the investment. But like the stockholder, the creditor is not responsible for the debts of the firm. Therefore, there is no fundamental difference between debt and equity capital. In a corporation, the assets and liabilities belong to the firm, not to its owners. As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity. Any profits belong to the entity and are paid out to the stockholders only when a dividend is declared. Under entity theory, all the items on the right-hand side of the balance sheet are viewed as claims against the assets of the firm, and individual items are distinguished by the nature of their claims. Some items are identified as creditor claims and others are identified as owner claims; nevertheless, they are all claims against the firm as a separate entity. Entity theorists take a broad view of the nature of the beneficiaries of income – both debtholders and equity-holders are compensated for investing in the firm. In essence, entity theory makes no distinction between debt and equity. Both are considered sources of capital, and the operations of the firm are not affected by the amount of debt relative to equity. Thus, under entity theory debt-to-equity ratios would not provide relevant information for investor decision making. The entity theory concept that there is no distinction between a company’s debt and equity is supported by the finance indifference theorem. Modigliani and Miller showed that, in theory, if we ignore taxes the company is indifferent between using debt and equity financing. This theory relies on the assumption that the sources of capital are unaffected by how the capital is invested. It also assumes that the income streams to debt and equity are equal and perpetual. Modigliani and Miller than added taxes to the equation and showed that the tax deductibility of interest would cause debt to be preferred to equity financing. However, Miller later showed that with arbitrage, that the tax deductibility of interest is irrelevant and thus, reestablished a theoretical basis for the finance indifference theorem.

Team 2:

Argue against elimination of the distinction between debt and equity. Support your argument by citing the proprietary theory of equity as well as finance theory that asserts that capital structure is relevant

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We believe that the current distinction between debt and equity in corporate balance sheets should continue. Our position is supported by proprietary theory which provides a better basis to account for the financial position and operations of businesses than does the entity theory. Under the proprietary theory, the interests of owners are seen as the guiding force in the preparation of financial statements because according to proprietary theory, the firm is owned by some specified person or group. Stockholders are owners. Creditors are not. Equity capital is different from capital raised by issuing debt. And, even though the stockholders are protected by limited liability, they do own the business. Stockholders have a right to participate in the business management of the corporation by casting their vote. In this way they are owners, acting as owners. Creditors do not participate in management. They simply provide capital. From a potential investor’s viewpoint, debt and its potential effect on the company is an important factor. The investor will weigh the risk of loss associated with corporate debt against the potential for high profits from financial leverage. When we calculate the return to common equity, the financial leverage and ROE vary directly. This the distinction between debt and is an important factor when evaluating firm performance. We reiterate. Equity is not like debt. Equity is the basic risk capital of an enterprise. Unlike debt, equity capital has no guaranteed return and no timetable for the repayment of the capital investment. From the standpoint of enterprise stability and exposure to risk of insolvency, a basic characteristic of equity capital is that it is permanent and can be counted on to remain invested in good times as well as bad. Consequently, equity funds can be most confidently invested in long-term assets and it is generally thought that equity funds can be exposed to the greatest potential risks. Consistent with proprietary theory, the business belongs to the owners. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners’ liabilities. Revenues received by the firm immediately increase the owner’s net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. Proprietary theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they are distributed. Therefore, the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as assets – liabilities = proprietorship Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company’s financial statements. This premise is consistent with the manner in which balance sheets are constructed and performance is measured. GAAP does distinguish liabilities from equity capital. GAAP does presume that the income earned by the company does belong to its owners. For example, the construction of consolidated statements separates income according to the type of stock owned by stockholders. Parent company stockholders are assigned their share of income while noncontrolling stockholders are assigned theirs. None of the corporate income is assigned to debt. In addition, we find other significant accounting policies that can be justified only through acceptance of the proprietary theory. For example, the calculation and presentation of earnings per share figures are relevant only if we assume that those earnings belong to the shareholders prior to the declaration of dividends.

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Current accounting practice continues to make a sharp distinction between debt and equity. Moreover, as pointed out above, the amount of debt relative to equity is generally considered an important indicator of risk. Such a distinction implies that accountants must separately identify and classify liabilities from equities. The Conceptual Framework defines debt and equity as two separate and very different financial statement elements. Given the Conceptual Framework objective that financial statements should report each element in a representationally faithful manner, from a theoretical standpoint, a company should distinguish debt from equity. In addition, we should strive to separate a complex financial instrument into its various parts and report each part in accordance with the financial statement element it meets the definition of. The FASB not only favors the position that balance sheets should distinguish between debt and equity, but also intends to make determinations on how to accomplish such distinctions between the components of complex financial instrument. WWW Case 15-14

1. b, j 2. a, e, i 3. e, h, i 4. b, j 5. j 6. e 7. a, e, i 8. b, e, j 9. d, j Case 15-15 The solution to this case is dependent upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions. Financial Analysis Case Answers will vary depending on the company selected.

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____________________________________________________ CHAPTER 16 Case 16-1

The cost of property, plant and equipment includes all expenditures to acquire the property, plant and equipment and to put it into position and condition for use. Among the expenditures which might be applicable to a purchase are the following: 1. Purchase price, less all discounts and applicable interest, plus the fair value of any other obligations assumed therewith--or an apportionment of the total if bought in a lump-sum purchase. 2. Title costs for items such as surveys, searches, registrations, unpaid taxes and accrued interest, action to obtain clear title and legal services. 3. Positioning costs such as freight, insurance in transit, duties, drayage and reinstallation. 4. Conditioning costs prior to normal use such as repairs, remodeling, reconditioning, test runs, renovation, insurance and taxes, draining, clearing, landscaping, grading, materials, direct and indirect labor and depreciation of equipment used in the conditioning effort. 5. Improvement or betterment costs to increase the value or extend the normal service life of the property, plant and equipment. even after putting it to normal operating use.

Majority ownership and administrative control are the two most important criteria for determining whether to consolidate the financial statements of Bevo Corporation and Casco, Inc. Other criteria include the extent to which Casco contributes directly to the activities of Bevo, existence of a large proportion of intercompany transactions, absence of restrictions by outsiders upon assets and earnings of the subsidiary, expectation of continued financial control, general coincidence of accounting periods and the general homogeneity of the assets and operations of the affiliate.

ii. Casco appears to be a captive of Bevo, financially and administratively. Casco is controlled through Bevo's board of directors and it is not unusual for a captive subsidiary to be liquidated when its usefulness has ended. Consolidated financial statements for Bevo and Casco therefore seem more appropriate and informative than separate financial statements. c.

Treating the $75,000 advance to Casco as an account receivable does not seem appropriate even though the nature of the advance suggests that the transaction was a loan to an affiliate. Bevo's advance was not an operating loan to an affiliate in need of working capital or temporary liquidity. It served only to clear Bevo's title to the property, plant and equipment of Algo's division. Also, the fact that Casco was formed for this purpose implies that the advance would not be paid back except perhaps through 246

an exchange of the Algo shares purchased from the minority stockholder, an exchange which could be made at will by Bevo and therefore has little substance. Finally, accounts receivable generally are related to receivables from normal trade with customers. ii. Treating the entire $75,000 advance as an investment in Casco is not appropriate even though stock of Algo was purchased by Casco with the $75,000 because the underlying value of the related assets was only about one half of this cost. In addition Bevo's board would not invest in Algo as a purchase agreement with Algo and had nothing to gain in the way of control of the majority. It also would not be likely to invest more in an entity managed by a management with divergent views. Therefore, one half of the $75,000 should be treated as an investment in Casco (the value of the Algo stock purchased by Casco) with the remainder treated as a cost of property, plant and equipment. iii. Treating the entire $75,000 advance to Casco as a cost of property, plant and equipment purchased from Algo does not seem appropriate although in substance the transaction was an attempt to obtain clear title to the property, plant and equipment. It is of course true that had the minority stockholder not intended to exercise his right to prevent the purchase, Casco would not have been formed and the advance would not have been made. To the extent that a portion of the $75,000 cost of the Algo stock can be attributed to the market value of the Algo stock, Bevo should treat that amount as an investment in Casco. After this allocation all that remains of the $75,00 advance should be treated as a part of the cost of property, plant and equipment of the manufacturing division purchased from Algo. If it is assumed that the original negotiated price reflected the fair market value of the property, plant and equipment purchased, that part of the $75,000 which is in excess of the fair market value should be treated as an intangible asset and classified as goodwill. iv. Treating the $75,000 advance as a loss does not seem appropriate because a loss is a reduction of equity, other than withdrawals of capital, for which no compensating value had been or is expected to be received. It was not an expired cost, one without benefits to the revenue producing activities of the enterprise. The $75,000 advance served a useful purpose: removing probable future actions to prevent the purchase or, failing that, to seek equity. This treatment might be appropriate if the $75,000 raised the cost of the property, plant and equipment far beyond its economic usefulness. However, this condition is unlikely in this situation because Bevo's board would not have pursued the agreement or taken the action it did unless the additional costs of obtaining clear title were economically justifiable. Case 16-2 a.

Whit Company should allocate the purchase price to the assets acquired and liabilities assumed. First, all identifiable assets acquired, either individually or by type, and liabilities assumed in the business combination, whether or not shown in the financial statements of Berry Company, should be assigned a portion of the cost of Berry Company, normally equal to their fair values at the date of acquisition. Goodwill is determined as the excess of the purchase price over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed.

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In deciding upon consolidation policy, the aim should be to make the financial presentation that is most meaningful in the circumstances. Berry Company should be included in the entity's consolidated financial statements from the date of the purchase. The usual condition for consolidation is control as evidenced by ownership of a majority voting interest. Therefore, as a general rule, ownership by one company, directly or indirectly, of over fifty percent of the outstanding voting shares of another company is a condition pointing toward consolidation.

Case 16-3 a.

Under FASB ASC 280,t here are three basic tests to be applied to segments of an industry to see if they are significant enough to be separately reportable. If a segment meets any one of the tests it is deemed significant and reportable. The first test is based upon revenue. If a segment's revenue from sales to unaffiliated customers and intersegment sales and transfers is equal to 10 percent or more of the enterprise's combined revenues, the segment is reportable. The second test is based upon operating profits or losses. There are two subtests in this category based upon absolute amounts of operating profits or losses. A segment is deemed reportable if the operating profit or loss shown by the segment is equal to or greater than 10 percent of the higher of the following two absolute amounts: (a) Sum of all operating profits for all segments reporting operating profits. (b) Sum of all operating losses for all segments reporting operating losses. Third, a segment is significant and reportable if the identifiable assets of the segment equal or exceed 10 percent of the combined identifiable assets of all of the industry segments within the enterprise. Finally, all segments, whether deemed reportable or not, must be reviewed from the standpoint of interperiod comparability, because the primary purpose of presenting segment information is to aid the financial statement reader.

Statement of Financial Accounting Standards No. 14 stated that enough industry segments must be separately reported so that the total of revenues from sales to unaffiliated customers for the reportable segments equals or exceeds 75 percent of the combined revenues from sales to unaffiliated customers for the entire enterprise. If applying the prescribed tests does not yield the required percentage of revenues described above, additional segments must be reported on until the 75 percent test is met. The Financial Accounting Standards Board has stated that if an enterprise has many reportable segments, benefit to the reader may be lost if more than 10 segments are reported. In such a situation, the board suggests combining related reportable segments until the total is ten or fewer

Under FASB ASC 280-10-50, the following segmental information is required to be disclosed:

a. Factors used to identify the public entity's reportable segments, including the basis of organization (for example, whether management has chosen to organize the public entity around differences in products and services, geographic areas, regulatory environments, 248

or a combination of factors and whether operating segments have been aggregated) Types of products and services from which each reportable segment derives its revenues. Additionally, information about profit or loss and assets each reportable segments should be disclosed, including all of the following about each reportable segment if the specified amounts are included in the measure of segment profit or loss reviewed by the chief operating decision maker or are otherwise regularly provided to the chief operating decision maker, even if not included in that measure of segment profit or loss b. c. c. d. e. f. g. h. i. j.

Revenues from external customers Revenues from transactions with other operating segments of the same public entity Interest revenue Interest expense Depreciation, depletion, and amortization expense Unusual items as described in paragraph 225-20-45-16 Equity in the net income of investees accounted for by the equity method Income tax expense or benefit Extraordinary items Significant noncash items other than depreciation, depletion, and amortization expense.

Case 16-4 The term measure, as used by the Financial Accounting Standards Board, refers to the quantification of an attribute of an item in a unit of currency other than the reporting currency. In this respect, transactions or balance reflected on a foreign financial statement are expressed in terms of U.S. dollars by applying the appropriate exchange rate to the foreign amount. This process is referred to as translation. It is possible to measure a given transaction or balance in terms of any other currency if the appropriate exchange rate is known. An asset or liability is denominated in a foreign currency if the liability or right to receive is fixed in terms of the foreign currency, regardless of the exchange rate. When an account receivable (or payable) is created and stated in fixed amounts of the foreign currency, the entity has the right (obligation) to receive (pay) the originally stated number of units of foreign currency. A change in the exchange rate between the date of the right to receive (obligation to pay) and the date the asset (liability) is received (paid) gives rise to an exchange gain or loss. An asset or liability may only be denominated in one currency. Any given transaction may be measured in one currency and denominated in another currency. An example of such a transaction would be the purchase of goods for sale by a German subsidiary of a U.S company (measuring the transaction in German marks) from a British company payable (denominated) in pounds sterling. A transaction may also be measured and denominated in the same foreign (with respect to a parent company) currency. An example of this type of transaction would be a British subsidiary of a U.S. company purchasing an asset from another British company. In this example the British subsidiary would measure the transaction in pounds sterling and would subsequently satisfy the debt in pounds sterling.

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In the first example, a change in the exchange rate between the date of the purchase of the goods and the settlement of the debt would cause the debt to be paid at an amount different from the original balance measured in U.S. dollars at the date of the transaction. This difference arises because a fixed amount of pounds sterling must be paid in order to settle the debt regardless of the cost to obtain the pounds sterling. In the second example, the subsidiary measures its transactions in the currency in which the debt is denominated, and so a subsequent change in the exchange rate of pounds sterling to U.S. dollars would have no effect on the amount of debt owed. Case 16-5 The temporal method generally translates assets and liabilities, expressed in foreign currency in a manner that retains the accounting principles used to measure them in foreign statements, and is characterized by the following: a.

Cash or amounts receivable or payable that are denominated in a local foreign currency are to be translated using current rates. All other assets and liabilities that are not classified as above are to be translated in a manner that retains their original measurement bases. The historical rate is to be used for accounts that are carried at prices in past exchanges, and the current rate is to be used in translating accounts that are priced in current or future exchanges. The balances in long-term accounts receivable and long-term accounts payable represent amounts receivable or payable denominated in local foreign currency and as such must be translated at the current rate of exchange.

Revenues and expense accounts are to be translated at the average exchange rate in effect during the period being reported upon. However, revenue and expense balances related to assets and liabilities translated at historical rates are translated at the rate in existence at the time the asset or liability was attained. Examples of revenue and expense accounts to be translated at historical rates are depreciation, amortization, inventory changes in cost of goods sold, and recognition of deferred income.

Inventory valued at cost and deferred income each represent accounts measured in past exchanges and must be translated at historical rates.

Long-term debt is translated at the current rate.

Case 16-6 a.

For a derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item. The effect of that accounting is to adjust the basis of the hedged item by the amount of the gain or loss on the hedging derivative to the extent that the gain or loss offsets the loss or gain experienced on the hedged item.

A derivative instrument that is designated as hedging changes in the fair value of an unrecognized firm commitment qualifies for the accounting treatment of a fair value hedge if all 250

of the specified criteria for hedge accounting under SFAS No. 133 are met. A derivative instrument that is designated as hedging the changes in the fair value of an available-for-sale security also qualifies for the accounting treatment of a fair value hedge if all of the same specified criteria are met. c.

Derivative instruments designated as hedging the foreign currency exposure to the variability in the functional-currency-equivalent cash flows associated with either a forecasted foreigncurrency-denominated transaction (a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency) or a forecasted intercompany foreign-currencydenominated transaction (a forecasted sale to a foreign subsidiary) qualify for hedge accounting under the following conditions: i. The company with the foreign currency exposure is a party to the hedging instrument ii.. The hedged transaction is denominated in a currency other than that unit's functional currency iii. All of the qualifying criteria for hedge accounting contained in SFAS No. 133 are

Case 16-7 a.

The guidelines contained at FASB ASC 830 adopt the functional currency approach to translation. An entity's functional currency is defined as the currency of the primary economic environment in which it operates, which will normally be the environment in which it expends cash. Most frequently the functional currency will be the local currency, and four general procedures are involved in the translation process when the local currency is defined as the functional currency. 1. The financial statements of each individual foreign entity are initially recorded in that entity's functional currency. For example, a Japanese subsidiary would initially prepare its financial statements in terms of yen, as that would be the currency it generally uses to carry out cash transactions. 2. The foreign entity's statements must be adjusted (if necessary) to comply with generally accepted accounting principles in the United States. 3. The financial statements of the foreign entity are translated into the reporting currency of the parent company (usually the U.S. dollar). Assets and liabilities are translated at the current exchange rate at the balance sheet date. Revenues, expenses, gains, and losses are translated at the rate in effect at the date they were first recognized. 4. Exchange gains and losses are accumulated and reported as a separate component of stockholders' equity in the unrealized capital section. FASB ASC 830 defines two situations in which the local currency would not be the functional currency. 1. The foreign country's economic environment is highly inflationary (over 100 percent cumulative inflation over the past three years such as recently experienced by Argentina and Brazil). 2. The company's investment is not considered long-term. 251

In these cases the foreign company's functional currency is defined by the U.S. dollar and the financial statements are translated using the FASB Statement No. 8 approach. That is: 1.

Each transaction was recorded at the historical exchange rate (the exchange rate in effect at the transaction date).

2. All cash, receivables, and payables denominated in foreign currencies were adjusted using the current rate at the balance sheet date. 3. All assets carried at market price were adjusted to equivalent dollar prices on the balance sheet date. 4. For all other assets, the particular measurement basis were used to determine the translation rate. 5. Revenues and expenses were translated in a manner that produced approximately the same dollar amount that would have resulted had the underlying transactions been translated into dollars on the dates they occurred. An average rate could be used in most cases. 6. All exchange gains and losses were included in the determination of net income. 7. Gains and losses on forward exchange contracts (agreements to exchange currencies at a predetermined rate) entered into to hedge a foreign currency–exposed net asset or liability position or to speculate were included in net income, while gains and losses on forward exchange contracts intended to hedge an identifiable foreign currency commitment were typically deferred. 8. All exchange gains and losses str reported as a component of income. b.

Under the guidelines contained at FASB ASC 830, translation is the purpose of expressing financial statements measured in one unit of currency (the reporting currency). The translation process is performed for the purpose of preparing financial statements and assumes that the foreign accounts will not be liquidated into U.S. dollars. Therefore, translation adjustments are disclosed as a part of stockholder's equity rather than as adjustments to income. Remeasurement is significantly different from translation and is the process of measuring transactions originally denominated in a different unit of currency (e.g., purchases of a German subsidiary of a U.S. company payable in French francs). Remeasurement is required when: 1. A foreign entity operates in a highly inflationary economy. 2. The accounts of an entity are maintained in a currency other than its functional currency. 3. A foreign entity is a party to a transaction that produces a monetary asset or liability denominated in a currency other than its functional currency. Remeasurement is virtually the same process as described earlier under the temporal method. That is, the financial-statement elements are restated according to their original measurement bases. It assumes that an exchange of currencies will occur at the exchange rate prevailing on the date of remeasurement. This produces a foreign exchange gain or loss if the exchange rate fluctuates between the date of the original transaction and the date of the assumed exchange. Therefore, any exchange gain or loss is included in the period in which it occurs.

Case 16-8 252

Entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners. Thus, the entity theory acquisition value for goodwill would be based on acquiring 100% of the subsidiary’s goodwill, no matter what the percentage ownership interest the parent company acquires. The typical entity theorist would infer the 100% value of goodwill from the amount pays by the parent company for its interest in the subsidiary. If, for example, the parent company pays $108,000 for a 90% interest in the subsidiary, and the fair value of the subsidiary’s net assets is $100,000. The parent is presumed to have purchased 90% x $100,000 = $90,000 of the identifiable net assets of the subsidiary. The other $18,000 ($108,000 - $90,000) is considered payment for 90% of the subsidiary’s goodwill. If $18,000 = 90% x goodwill, then the value of goodwill is presumed to be $18,000 / 90% = $20,000.

Because entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at 100% of their respective fair values, including goodwill. Thus, the noncontrolling interest must be valued at their percentage ownership in the subsidiary multiplied times the fair value of those net assets. The typical entity theorist would infer the value of the total subsidiary from the purchase price the parent company pays for the ownership interest the parent company purchases. For example, if the parent company pays $108,000 for a 90% interest in the subsidiary, the fair value of the net assets of the subsidiary (including goodwill) are presumed to be $108,000 / 90% = $120,000. Noncontrolling interest would be valued at $120,000 x 10% = $12,000.

Because the net assets of the consolidated entity are viewed as belonging to the consolidated entity, any income generated by them belongs to the consolidated entity, not to any particular equity holder. The bottom line of an entity theorist’s consolidated income statement would be consolidated net income. Consolidated net income would include the revenues, expenses, gains and losses of the entity. In the entity theorist’s income statement, consolidated net income would not be allocated between the parent company and the noncontrolling interest. An allocation of the consolidated net income between the parent company and the noncontrolling interest could be separately shown so that the user could see how the parent company’s share of the consolidated net income impacts the parent company’s retained earnings and how the noncontrolling interest‘s share of the subsidiary income (that is included in consolidated net income) impacts the balance of the noncontrolling interest that is reported in the consolidated balance sheet.

Because entity theory views the assets of the consolidated entity as belonging to the entity, rather than to its owners, both creditors and stockholders of the consolidated group are seen as providers of capital. A strict entity theorist, such as William Paton, would say that all capital providers should be listed on the right side of the balance sheet with no distinction being made for debt versus equity.

e. However, the typical entity theorist would say that noncontrolling interest in the subsidiary is an equity interest and should be reported in stockholders’ equity along with the parent company’s equity in the consolidated entity. He/she would argue that noncontrolling interest does not meet the definition of a liability; rather, noncontrolling interest has all the characteristics of an equity interest just like the parent company’s interest in the consolidated entity has. The only 253

difference is that the noncontrolling interest has an interest in only a part of the consolidated entity (the subsidiary), but nevertheless it is still an equity interest 16-9 a.

Parent company theory views the assets and liabilities of the consolidated entity as belonging to the owners, not to the entity. In addition, parent company theorists believe that consolidated financial statements are constructed primarily for the parent company stockholders and that a noncontrolling interest is an outside interest. Thus, the parent company theory acquisition value for goodwill would be based only on the goodwill presumed to have been purchased by the parent company. If, for example, the parent company pays $108,000 for a 90% interest in the subsidiary, and the fair value of the subsidiary’s net assets is $100,000. The parent is presumed to have purchased 90% x $100,000 = $90,000 of the identifiable net assets of the subsidiary. The additional amount paid to purchase the parent’s company’s interest is deemed to be goodwill. Goodwill = $108,000 - $90,000 = $18,000.

Because parent company theory views the assets and liabilities of the consolidated entity as belonging to the owners of parent company shares, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at historical cost from the perspective of the parent company. Thus, the value of the net assets of an acquired subsidiary are initially valued at 100% of their respective book values plus the parent company’s share of the adjustment of those assets and liabilities to fair value. In addition purchased goodwill is added to the subsidiary’s assets. The result is that the value of noncontrolling interest is not affected by the consolidation process. It will be equal to the noncontrolling interest’s ownership percentage multiplied times the book value of the subsidiary’s equity. In the above example, if the book value of the identifiable net assets of the subsidiary on the acquisition date is equal to $94,000, the difference between their fair value and book value would be ($100,000 - $94,000) = $6,000. On the acquisition date, the balance sheet of the consolidated entity would include subsidiary net assets valued at $94,000 + 90% x 6,000 plus goodwill of $18,000. It would also report noncontrolling interest equal to 10% x $94,000 = $9,400.

Because the parent company theorist views the financial statements of the consolidated entity as being provided solely for the parent company shareholders and thus views the noncontrolling interest as an outside interest, the noncontrolling interest’s share of the subsidiary’s net income is subtracted from the consolidated entity’s net income to arrive at parent company net income. Some parent company theorists would show the noncontrolling interest income as an expense others would show it as a subtraction to arrive at parent company net income.

Because the parent company theorist views the financial statements of the consolidated entity as being provided solely for the parent company shareholders and thus views the noncontrolling interest as an outside interest, only the parent company shareholders are viewed as an equity interest. Even though the noncontrolling interest represents a shareholder interest in the subsidiary, the parent company theorist would not place noncontrolling interest in stockholders’ equity. It would be reported either in the liability section of the balance sheet or between liabilities and stockholders’ equity. 254

16-10 Current practice values the net assets of a consolidated entity at 100% of their fair value, regardless of the percentage ownership that the parent company has in its subsidiary. Because entity theory views the assets and liabilities of the consolidated entity as belonging to the entity, not to its owners, when a parent company acquires less than a 100% ownership interest in a subsidiary, the assets and liabilities are valued at 100% of their respective fair values. Current practice requires companies to value noncontrolling interest at fair value. Consequently, goodwill is also valued at fair value. The result is that all assets and liabilities are valued at their respective fair values. The entity theory result would be identical with one possible exception. The entity theorist would use the value of goodwill purchased by the parent to infer the 100% fair value of goodwill and thus the fair value of the noncontrolling interest. Current practice will allow parent companies to do the same, but seems to prefer a separate determination of the fair value of noncontrolling interest based on share price or some other method, and thus the valuation of noncontrolling interest in concert with the valuation of identifiable net assets determines the fair value of goodwill. Current practice requires companies to determine consolidated net income (which is called net income) and then subtract noncontrolling interest income to arrive at parent company net income. This is consistent with entity theory to the extent that both approaches call net income the amount that would otherwise be called total consolidated net income. However, an entity theorist would not then show an allocation in the income statement. Current practice requires that noncontrolling interest be included in the stockholders’ equity section of the balance sheet, but clearly separated from parent company equity. Total equity would include both. Entity theorists consider the net assets as belonging to the entity. Strict entity theorists would not have an equity section of the balance sheet because they see both debt holders and shareholders simply as capital providers. However many entity theorists would argue that because noncontrolling interest is an ownership interest in the subsidiary it is an ownership interest in at least part of the consolidated entity. Thus, it is an equity interest. FASB ASC 16-1 Cost Allocation for a Patent a.

Internally developed patents fall under the accounting for research and development costs section of the FASB ASC and the provisions of FASB ASC 730-25-1 and 730-5-2&3 consequently the patent should be recorded as an expense and should not be recorded as an asset.

Yes, the asset’s value on the acquired company’s books is irrelevant under FASB ASC 805-2030-1

FASB ASC 16-2 Consolidations and the EITF Search “new basis.” Found at 805-50. Then select the Printer Friendly with Sources function FASB ASC 16-3 Definition of Business Search business combinations and definition of a business 805-10-55-4 255

FASB ASC 16-4 Noncontrolling Interests Cross reference FAS 160 810-10-65 FASB ASC 16-5 Proportionate Consolidation Search proportionate consolidation 932-810-45 FASB ASC 16-6 Value beyond Proven and Probable Reserves Search value beyond proven and probable reserves 930-805-30 Definition found in glossary 930-805-20 FASB ASC 16-7 Demutualization of Life Insurance Companies Search Demutualization 944-805-05 FASB ASC 16-8 Affiliated Sales in the Consolidation of Regulated Industries Search consolidation and regulated operations and affiliated sales 980-810-45 Room for Debate Debate 16-1 Team 1 Argue in favor of presenting the noncontrolling interest as an element of stockholders’ equity The reporting of noncontrolling interest as an element of stockholders’ equity is consistent with the entity theory. According to entity theory, the consolidated group (parent company and subsidiaries) is an entity, separate from its owners. Thus, the emphasis is on control of the group of legal entities operating as a single unit. Consolidated net assets and the change in them (income) belongs to and is controlled by the consolidated entity. Consolidated assets belong to the consolidated entity, consolidated liabilities are obligations of the consolidated entity, and the income generated by investing in the consolidated assets is income to the consolidated entity 256

rather than to the parent company stockholders. Consequently, the purpose of consolidated financial statements is to provide information to all shareholders - parent company stockholders and outside noncontrolling stockholders of the subsidiary companies. Entity theory implies that all stockholders are stockholders in the consolidated group - i.e., that noncontrolling interest is an equity interest. The consolidated entity is considered as one economic unit, and noncontrolling stockholders contribute resources to the unit in the same manner as parent company stockholders. Noncontrolling stockholders have the same characteristics as parent company stockholders. Their interest is enhanced or burdened by changes in net assets from nonowner sources - a prerequisite for equities as defined and described in SFAC No. 6. For noncontrolling interest which owns common stock, they have the four basic rights of common stock inherent in the common stock of the parent company. They have the right to vote, to share in profits, to share in liquidation, and the preemptive right. The FASB defined minority interest (here termed noncontrolling interest) as meeting the definition of equity. Recently the FASB issued an exposure draft in which they reiterated this position. Noncontrolling interest does not meet the definition of a liability. It embodies no obligation for the future transfer of assets unless a dividend is declared (no different from parent company shares). If noncontrolling interest does not meet the definition of a liability and it is not an asset, under the present accounting model, it must be equity. Team 2 Argue in favor of presenting the noncontrolling interest outside of stockholders’ equity Presenting noncontrolling interest as an outside interest is consistent with parent company theory and IAS No. 27. According to parent company theory, only parent company stockholders have a proprietary interest in the net assets of the consolidated group. Under this theory, the purpose of consolidated statements is to provide information primarily for parent company stockholders, a view that is supported by ARB No. 51. As a result, consolidated financial statements reflect the parent company perspective in which the net assets of the subsidiary are substituted for the parent’s equity interest investment in the subsidiary resulting from the application of the equity method of accounting. As a result, consolidated net income equals parent company net income and consolidated equity is equal to parent company equity. Because only parent company stockholders play a proprietary role, noncontrolling shares are an outside interest and should not be included in consolidated stockholder’s equity. The consolidation process has no impact on the reporting entity and is of no benefit to noncontrolling shareholders. Noncontrolling shareholders have no interest in the parent company or any other subsidiaries of the parent company. Their interest is limited to a segment of the consolidated group, the subsidiary. They cannot exercise control over the consolidated entity, hence, they do not act as owners in the usual sense. Hence, they are not equity to the consolidated group. They represent an outside interest. Debate 16-2 Measurement Team 1 According to the guidance contained at FASB ASC 805, a company should measure the plant assets of an acquired company that it plans to use in its operations using replacement cost. This makes sense because, replacement cost measures the amount that a company would have to pay 257

to acquire the assets that it will use. In other words, we believe that an entry value is appropriate to measure the current value of assets in use. If the plant assets of an acquired company were measured in accordance with SFAS No. 157, the parent company would have to value assets acquired based on exit values. These exit values would be the values that the parent company could get from selling the assets in an orderly sale. If the parent company plans to use these assets, the value they could get from selling them is not relevant. Instead, the only relevant cost is the cost that it would take to acquire them in their current condition. Team 2 Fair value under the guidance contained at FASB ASC 820 is based on exit value. It is the amount that a company would receive from selling an asset in an orderly sale. The company always makes a choice to sell and replace an asset or to keep it. The exit value measures the opportunity to sell. Once owned, the opportunity to sell is the only relevant current value. Since the company already owns the asset, the opportunity to purchase another one just like it is not relevant. Since companies are always making replace or keep decisions, they are reinvesting in the asset by keeping rather than selling it. This is in effect a capital budgeting decision-making process. If you were trying to decide whether to sell or keep, you would compare the future cash flows for each alternative. The future cash flows to sell would be what you would get by selling the assets combined with the cost of acquiring a new one along with financing decisions, tax effects and potential effects on cash flow resulting from increased efficiency of a replacement asset. You would not be acquiring another asset in the same condition as the old one. The future cash flows to keep would be similar, but would not include the cost of replacement, since keeping the asset would negate its replacement. Debate 16-3 Goodwill of an acquired company SFAS No. 160 requires that Goodwill be measured at 100% of its fair value. Team 1: Argue that Goodwill reported in balance sheets should only be measured at the value purchased by the parent company. Your arguments should refer to parent company theory.

According to parent company theory, consolidated statements are prepared only for the benefit of parent company stockholders. The parent company and its subsidiary companies are controlled by the parent company and thus by the owners of the parent company (the parent company stockholders). Parent company theorists argue that the parent and subsidiary businesses operate for the benefit of parent company shareholders, rather than for the benefit of noncontrolling subsidiary stockholders. From the parent company’s perspective, the parent company has purchased an interest in each subsidiary that it controls. The parent company paid to obtain subsidiary shares. If less than 100% of the shares of any subsidiary are owned by the parent company, the amount paid to acquire control of the net assets of a subsidiary is less than 100% of the value of those net assets on the acquisition date. Any additional amount paid to purchase subsidiary shares is assumed to have been spent to purchase the parent company’s share of the subsidiary’s goodwill. 258

From the parent company’s perspective, reporting only the amount of goodwill that is purchased by the parent company is consistent with the historical cost principle. The remaining amount of goodwill was not purchased. Since the historical cost principle implies that the initial cost of an asset is equal to the price paid for it plus all costs necessary to acquire it and get it ready for its intended use, the amount of goodwill purchased by the parent company is its historical cost. An additional argument for reporting only the portion of goodwill that is purchased by the parent company is the argument that the parent may have paid more to acquire subsidiary shares in order to obtain control of the subsidiary. This extra amount is called a control premium. If a control premium was paid, the amount of the purchase price assigned to goodwill is equal to the value of purchased goodwill plus the control premium. Thus, by assigning all of the excess amount paid to purchase subsidiary shares to goodwill, means that the value reported as the purchase price of goodwill is overstated. So, if the parent company would then use the price paid to purchase subsidiary shares as a basis to infer the amount of the subsidiary’s total goodwill would result in an additional overstatement of goodwill. Team 2: Argue that Goodwill reported in balance sheets should be the amount of goodwill for the total company acquired. Your arguments should refer to entity theory.

According to the entity theory, the parent company and its subsidiaries are a single entity. The consolidated group is an entity, separate from its owners. Thus, the emphasis is on control of the group of legal entities operating as a single unit. All of the assets belong to the entity. All of the debts are debts of the entity. And the income earned by investing in those assets is income to the consolidated entity rather than to either the parent company stockholders or to the subsidiary’s noncontrolling stockholders. Consequently, the purpose of consolidated statements is to provide information to all shareholders—parent company stockholders and outside noncontrolling stockholders of the subsidiaries. Stockholders (both parent company stockholders and stockholders that comprise the noncontrolling interest in subsidiaries of the parent company provide capital to the entity. The earnings accrue to the entity and are distributed to providers of capital – debt holders and stockholders. The revision of SFAS No. 141 and the FASB’s requirements outlined in SFAS No. 160 are consistent with entity theory. Companies are now required to report 100% of the fair value of both the assets and liabilities of an acquired company even when there is a noncontrolling interest remaining in the acquired company or subsidiary. The noncontrolling interest must be measured initially at its fair value which means that its initial value is no longer unaffected by the consolidation process. The result is that goodwill is now reported at the amount purchased by the parent company plus the noncontrolling interest’s share as measured by its fair value. This treatment is consistent with the initial measurement of an asset at its fair value. At acquisition, an asset’s fair value is equal to what it could be sold for in an ordinary exchange transaction. The parent company’s purchase of a controlling interest in the subsidiary is an arm’s length transaction and thus the fair value of the share of the subsidiary that was purchased. The fair value of the noncontrolling interest’s share of goodwill is determined by first measuring the fair value of the noncontrolling interest itself. The resulting fair value of goodwill is relevant to users of the financial statements. From their perspective the partial fair value adjustment that 259

would occur under the parent company theory represents neither historical cost nor fair value. As such it provides a less meaningful measure of goodwill. Since we are reporting a consolidated entity, why not report the total value of its assets rather than adding together the fair value acquired by the parent company plus the noncontrolling interest’s share of the historical cost of those assets? WWW Case 16-11 a.

Financial reporting for segments of a business enterprise involves reporting financial information on a less-than-total enterprise basis. These segments may be defined along organizational lines, such as divisions, branches, or subsidiaries. Segmentation could be based on areas of economic activity, such as industries in which the enterprise operates, product lines, types of services rendered, markets, types of customers, or geographical areas. In addition to these possible individual definitions of an enterprise’s segments, a company may use more than one of the above-cited bases of segmentation. The reasons for requiring financial data to be reported by segments include the following: 1. They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements. 2. Appraisers can evaluate major segments of a business enterprise before considering the business in its entirety. 3. In addition to being useful and desirable, such information is practical to compute. 4. The growth potential of an enterprise can be evaluated by reviewing the growth potential of its major segments. 5. Users can better assess management decisions to drop or add a segment. 6. Projection of future earning power is made more effective when approached on a segment basis because different segments may have differing rates of growth, profitability, and degrees of risk. 7. Managerial ability is better assessed with segment data because managerial responsibility within the enterprise is frequently decentralized. The possible disadvantages of requiring financial data to be reported by segments include the following: 1. They could be misinterpreted due to the public’s general lack of appreciation of the limitations of the somewhat arbitrary bases for most allocations of common costs. 2. They may disguise the interdependence of all the segments. 3. They might result in misleading comparisons of segments of different enterprises. 4. Confidential information would be revealed to competitors about profitable or unprofitable products, plans for new products or entries into new markets, apparent weaknesses that might induce competitors to increase their own efforts to take advantage of the weakness, and the existence of advantages not otherwise indicated. 5. Information thus made available might cause customers to challenge prices to the disadvantage of the company. 6. Operating data reported by segments might be misleading to those who read them. Segment data prepared for internal management purposes often include arbitrary judgments that are known to those using the data and taken into account in making evaluations. The difficulty of making such background information available and understandable to outside users is considered by many to be insurmountable. 260

The accounting difficulties inherent in segment reporting include the following: 1. The transfer prices must be determined. Transfer prices are those charged when one segment deals with another segment of the same enterprise. Various possible transfer prices exist, and the company must select one. 2. The computation of segment net income must be defined. The net income may be merely a contribution margin, that is, sales less variable costs, or a more conventional measure of net income. If a contribution-margin approach is used, the variable costs must be identified. If a more conventional measure of net income is used, the treatment of various items for each segment’s net income must be established. Such items include the following: i. Determining whether common costs should be allocated to segments. ii. Selecting allocation bases if common costs are to be allocated. iii. Determining which costs of capital (interest, preferred dividends, etc.) should be attributed to segments.

Case 16-12 The solution to this case is dependent upon the companies selected by the students. A recommended method of checking the students’ solutions is to require them to turn in their downloaded financial statements with their solutions. Financial Analysis Case Answers will vary depending on company selected

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CHAPTER 17 Case 17-1 The position that mandatory accounting and auditing standards inhibit contracting arrangements and the ability to report on company operations is an agency theory argument. This argument holds that regulators will be affected by external pressures, and will act to maximize their own utilities. This position was first advanced by Watts and Zimmerman in "Toward a Positive Theory of the Determination of Accounting Standards" the Accounting Review, January, 1978, pp. 113-134). They concluded that management will lobby on accounting standards based on its own self-interest. To the extent that management can increase either its level of incentive compensation, or its firm's share price via accounting standards, they are better off. Other factors affecting management wealth are taxes, regulation, political costs, information production and management compensation plans. A management position on a particular accounting standard depends on the size of the firm (which affects political costs) and whether or not the standard will affect earnings. They concluded that as long as financial accounting standards have potential effects on future cash flows, standard setting bodies will be influenced by corporate lobbying. The opposing view that market forces cannot be relied on to produce information is a critical perspective viewpoint. Individuals taking this position point to various failures in our system such as the saving and loan crisis, the housing crisis and audit failures as evidence that the system is not working. They maintain that various individuals and groups have the ability to influence standard setting. They maintain that large corporations have pressured standard setters to protect their own interests. It should be noted that both viewpoints come to the same conclusion but differ in their approaches to solving what they see is the problem. The marginalists favor a completely free market with no rules; whereas, the critical perspectivists favor government intervention into the standard setting process. Case 17-2 The following is one solution. Students may find other issues. a.

It is not ethical for Barbara to work hours and not charge them to the client. This is a violation of the firm's employment policy that could cause her to be dismissed. This practice could also cause problems is subsequent years when the amount of hours necessary to complete the Lakes Brothers audit in compared to the current year.

1. Obtain the relevant facts. - Barbara Montgomery is being pressured to work hours on the Lakes Brothers audit "off-the-clock." 2. This practice is against her auditing firm’s employment policy, a violation that could cause her to be dismissed. This practice could also cause problems in subsequent years when the 262

amount of hours necessary to complete the Lakes Brothers audit is compared to the current year. 3. The individuals affected by this decision are Barbara, Robert Cooley her supervisor, the partner in charge of the job, the accounting firm Coopers and Rose, subsequent years' audit teams and the client Lakes Brothers. 4. Possible alternative solutions: a. b. c. d.

work "off-the-clock" Refuse to work "off-the-clock" Report the situation to the partner in charge of the audit Report the situation to a mentor or an ombudsman within the firm and ask for advice.

5. Possible outcomes of alternative solutions: i.

Barbara will be seen as a team player by her immediate colleague. Robert Cooley will be assisted in bringing the job in at or under Budgeted hours. The partner in charge will be misled about the hours necessary to actually complete the job. The firm and the client will also be mislead as to the actual hours necessary to complete the job

ii.

Barbara will not be viewed as a team player. Cooley will probably give her an unfavorable review; and he will be less likely to buy the job in under budget. The partner in charge will be informed about the hours necessary to complete the job but may be faulted by others in the firm for failing to buy the job at budget. However, the original situation may not be exposed. The firm and the client will be unhappy because the job has not been completed within budged hours; however, they will be informed of the time necessary to actually complete the job.

iii.

This alternative depends upon whether or not the partner is also pressuring Cooley to have staff members work “off-the-clock." Assuming the situation is all Cooley's idea, Barbara will be bringing a violation of company policy to the partner's attention. Cooley faces discipline. The firm and the client will be more knowledgeable concerning the actual hours necessary to complete the job.

iv.

This is a possible solution that may not directly affect Barbara Montgomery. An internal investigator will probably cause Cooley to be disciplined. However, the other partners will be affected in a manner similar to C. The most appropriate action is D if it is available. This alternative does not cause Barbara to directly confront a superior in the firm and ensure that the violation will be exposed at the highest levels of the firm.

Case 17-3 Item 1 a.

Unless cumulative preferred dividends are involved, no recommendations by the CPA are required. Common stock dividend policy is understood by readers of financial statements to be discretionary on the part of the board of directors. The company need not commit itself to a 263

prospective common stock dividend policy or explain its historical policy in the financial statements, particularly since dividend policy is to be discussed in the president's letter. If cumulative preferred dividends are omitted, this should he disclosed in the financial statements or a footnote. b.

No comment or opinion qualification is required in the auditor's report on the financial statements unless an omission of cumulative preferred dividends is not properly disclosed. Item 2

The staff auditor reviewing the loan agreement misinterpreted its requirement. Retained earnings are restricted in the amount of $298,000, which was the balance of retained earnings at the date of the agreement. The nature and amount of the restriction should be disclosed in the balance sheet or in a footnote to the financial statements.

Assuming Lancaster does not make the recommended disclosure, the nature of an amount of the restriction should be disclosed in the auditor's report, and the opinion should be appropriately qualified.

Item 3 a.

The lease agreement with the Sixth National Bank meets the criteria for an installment purchase of property: (1) it is noncancellable; (2) the company may purchase the property at the expiration date at a nominal price, substantially less than probable fair value: (3) the property meets special needs of the lessee; (4) the lessee is obligated to pay property taxes, insurance and maintenance. Accordingly, Mr. Olds should recommend that the property and the related obligation be stated in the balance sheet at the appropriate discounted amount of future payments under the lease agreement. The income statement should include annual financing charges applicable to the unpaid obligation and amortization of the cost of the property based upon its useful life. Additional footnote disclosure may be desirable

If Lancaster does not capitalize the installment purchase as recommended, Mr. Olds should explain the circumstances in his report and qualify his opinion as to conformity with generally accepted accounting principles (or express an adverse opinion, if the amounts involved are so material that in his judgment a qualified opinion is not justified).

Item 4 a.

A competitive development of this nature normally is considered to be the second type of subsequent event, one that provides evidence with respect to a condition that did not exist at the date of the balance sheet, but in some circumstances the auditor might conclude that Lancaster's poor competitive situation was evident at year-end. In any event, this development should be disclosed to users of the financial statements because the economic recoverability of the new plant is in doubt and Lancaster may incur substantial expenditures to modify its facilities. Because the economic effects probably cannot be determined, the usual disclosure will be in a footnote to the financial statements. If the present recoverable value of the plant can be determined, Lancaster should consider disclosure of the Company's revised financial position in a pro forma balance sheet, assuming that this event is concluded to be evidence of a condition that did not exist at year-end. (Only if circumstances were such that it was concluded that this 264

condition did exist at year-end should financial statements for the year ended December 31, 2014 be adjusted for the ascertainable economic effects of this development.) b.

If Lancaster does not disclose this event as the auditor recommends, the financial statements are misleading. Mr. Olds should take exception to the adequacy of disclosure and depending upon the degree of materiality, he may express an adverse opinion. A Subject to" opinion or disclaimer of opinion (neither of which is proper under the given assumption) might be justified if the development was adequately disclosed and the economic effects could not be determined. The occurrence of this event after the completion of field work does not affect the need for disclosure. The auditor generally is responsible for inquiry as to subsequent events only to the end of field work and dates his report accordingly, but he has the responsibility to evaluate subsequent information if it comes to his attention.

Case 17-4 a& b

.l. The auditor might recommend the following footnote be appended to the financial statements in regard to item 1. Note A. The federal income tax return filed by the Corporation for the year 2014 is being examined by the Internal Revenue Service. The Internal Revenue Service has questioned the amount of a deduction claimed by the Company's domestic subsidiary for a loss sustained in 2014. The examination by the Internal Revenue Service has not progressed to the point that would indicate the extent of the Company's liability. The Company's tax counsel believes that the Company will not be subject to any substantial income tax liability with respect to this matter. 2. Item 2. Nonaccounting matters such as management changes and pending proxy fights are not disclosed unless such information is needed for the proper interpretation of the financial statements. The president should be informed that footnotes are an integral part of the financial statements and as such should be limited to information that relates to the financial statements. Furthermore, there is no certainty that a proxy fight will materialize and, hence, in view of the uncertainty no reason for footnote disclosure. Disclosure of events that have no relevance to those matters essential to proper interpretation of the financial statements frequently creates doubt as to the reasons for disclosure and inferences drawn could be misleading. Information about the pending proxy fight might be included in the president's letter to the stockholders which is usually included in a company's annual report.

Case 17-5 a.

If a corporation's activity could be expected to be the same in all quarters, there would be no problems in using quarterly statements to predict annual results, providing one recognized that the normal activities of any corporation could be disrupted by unforeseen events such as strikes, fires, floods, actions of governmental authorities, and unusual changes in demand for goods or supply of raw materials. Most businesses, however, can be expected to have variations in activity among quarters. Any user of the financial statements who is not a member of management would probably have great difficulty in making accurate predictions.

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A basic cause of fluctuating quarterly activity is seasonality. Sales often show a seasonal pattern. Expenses also may show a seasonal pattern, but the pattern for any expense may differ from the patterns for sales or for the other expenses. Production, expressed in physical units, may show still another pattern. The more product lines a business has, the greater the number of varying seasonal patterns that may be present. b.

Repairs and Maintenance of Factory Machinery is an example of an item which may show substantial variations which are not proportionate to either sales or production. In fact, it would not be unusual for many repair and maintenance projects to be performed during the time when production is lowest, thus causing high unit costs (high costs divided by few units) for the quarter. The effect on income would be spread between the quarter of incurrence and later quarters depending on inventory levels and costing methods. Use of predetermined overhead rates would have the same effect (if variances were allocated between inventories and cost of goods sold) or else would confine the effect of the high costs to the current quarter (if variances were included in cost of goods sold). Low costs in periods of high production would result in low unit costs, the effects of which would be spread among quarters as described above.

Such quarterly statements do give management opportunities to manipulate the results of operations for quarter--for instance, through the timing of expenses. Management can defer some expenses in an attempt to make the results of earlier quarters look very profitable, thus delaying discovery of conditions which could reflect on management's performance. On the other hand, management can incur heavy expenses in the earlier quarters in an attempt to show a favorable trend in the later quarters. For example, the time at which maintenance work is undertaken is somewhat discretionary.

Case 17-6 a.

A variety of disclosure techniques are available in published financial statements. Among the most common are: 1. 2. 3. 4.

The financial statements. Footnotes to the financial statements. Supplementary statements and schedules. The auditor's report.

The financial statements should contain the most relevant and significant information about the corporation expressed in quantitative terms. The form and arrangement of the financial statements should be such as to insure that the most vital information is readily apparent to the financial-statement users. The footnotes should be used to present information that cannot be easily incorporated into the financial statements themselves. However, footnotes should never be used to substitute for the proper valuation of a financial-statement element nor should they be used to contradict information contained in the financial statements. The most common examples of footnotes are: 1. Schedules and exhibits such as long-term debt. 266

2. Explanations of financial statements such as pensions. 3. General information about the company such as subsequent events or contingencies. Supplementary statements and schedules are intended to improve the understandability of the financial statements. They may be used to highlight trends such as five-year summaries or be required by FASB pronouncements such as information on current costs. The auditor's report is a form of disclosure in that it informs the users of the reliability of the financial statements. That is, an unqualified opinion should indicate more reliable financial statements than would a qualified or adverse opinion. b.

The disclosure issues addressed by the AICPA's Code of Professional Ethics are: adequate auditing procedures, the use of acceptable accounting principles and independence.

ii. The disclosure issue addressed by the Securities Act of 1933 is the protection of the public from fraud when a company is initially issuing securities to the public. iii. The disclosure issues addressed by the Securities Exchange Act of 1934 are the personal duties of corporate officers and owners (insiders) and the corporate reporting requirements. iv. The disclosure issues addressed by the Foreign Corrupt Practices Act of 1977 are the prevention of bribery of foreign officials and the maintenance of adequate financial records. v. One of the more controversial provisions of SOX is Section 404 that contains two subsections sections – 404(a) and 404(b). 404(a) outlines management’s responsibility under the act, and requires that the annual report include an internal control report by management that: (1) Acknowledges its responsibility for establishing and maintaining adequate internal control over financial reporting and (2) Contains an assessment of the effectiveness of internal control over financial reporting as of the end of the most recent fiscal year. It also requires the principal executive and financial officers to make quarterly and annual certifications as to the effectiveness of the company’s internal control over financial reporting. Section 404(b) outlines the independent auditor’s responsibility. It. requires the auditor to report on the internal control assessment made by management and also to make a separate independent assessment of the company’s internal controls over financial reporting. The result of these provisions is to require the auditor to issue two separate opinions. The first opinion states whether management’ assessment is fairly stated, in all material respects. The second opinion indicates whether, in the auditor’s opinion, the company maintained, in all material respects, effective internal control over financial reporting as of the specific date, based on the control criteria used by management. In summary, the auditor reports: (1) on whether management’s assessment of the effectiveness of internal control is appropriate, and (2) whether he or she believes that the company has maintained effective internal control over financial reporting. 267

The cost of compliance with this legislation was seen by some as excessive. According to one study, the net private cost amounted to $1.4 trillion. This amount was obtained by an econometric estimate of the loss in total market value caused by SOX. That is, the costs minus the benefits as perceived by the stock market as the new rules were enacted. Zhang’s study has since been criticized on the grounds that no single factor can be attributed as the cause of stock market behavior. Her critics note that all of the stock market trends around the time SOX was enacted were attributed to the legislation, while the subsequent increase in market value was ignored. Never-the-less, a survey by the Financial Executives Institute in 2005 estimated that companies’ total costs for the first year of compliance with SOX averaged $4.6 million. . The new provisions that emphasize the importance of internal control have obvious benefit; however, a standard rule of thumb for internal control measures is that the benefits should outweigh their costs. Some critics of SOX maintain that its effect has been that the costs of regulation exceed its benefits for many corporations. SOX was effective for companies meeting the definition of accelerated filers (having an equity market capitalization of over $75 million and filing a report with the SEC) for fiscal years ending on or after December 15, 2004; consequently December 31, 2004 was the effective filing date for most of these companies. Companies that did not meet the definition of accelerated filers were initially required to comply with SOX’s provisions for fiscal periods ending on or after July 15, 2006. Case 17-7 a.

The Securities Act of 1933 regulates the initial public distribution of a corporation's securities. Issuing securities to the public for the first time is termed going public. The Securities Exchange Act of 1934 regulates the trading of securities of publicly held companies. Periodic reporting for publicly held companies is termed being public.

The main items now required to be analyzed and discussed by management are: 1. Unusual or infrequent events that materially affect the reported amount of income. 2. Trends or uncertainties having or expected to have a significant impact on reported income. 3. Changes in volume or price and the introduction of new products that materially affect income. 4. Factors that might have an impact on the company's liquidity or ability to generate enough cash to maintain operations. 5. Commitments for capital projects and anticipated sources of funds to finance these projects. 6. Companies are encouraged but not required to provide financial forecasts.

Case 17-8 a.

The accounting profession, similar to all professions, has a responsibility to provide quality service to the public. Because the body of knowledge in any profession is complex, the public often cannot evaluate the quality of a professional person's service. 268

By establishing rules of conduct, a profession assumes self-discipline beyond the requirements of law. In auditing, users of financial statements cannot be expected to always understand generally accepted accounting and auditing standards, and other complex areas of accounting and auditing knowledge. Through a code of professional ethics, CPAs provide assurances that quality services have been provided. b.

Public accounting firms are generally required to be organized as sole proprietorships or partnerships. Corporate organizational forms do not protect the public interest (That is, they shield the firm's personnel from liability). Although the legal liability question is now receiving a great deal of attention in the press through public statements by officials in large public accounting firms, attempts to limit legal liability through the formation of corporations have not yet been successful. The legal liability issue will continue to be an important topic in the near future.

Case 17-9 a.

From Mason Enterprises’ perspective, the lease is in substance a purchase of an asset, financed by debt. Capital leases embody the acquisition of future benefits similar to those acquired by purchases of long-term fixed assets. The fair value of the leased asset should be recorded because the benefits acquired meet the definition of an asset. The asset is controlled by the entity and results from a transaction, the initiation of the lease agreement. The obligation to make lease payments constitutes probably future sacrifices, a present obligation to pay cash in the future, resulting from a prior transaction, the initiation of the lease agreement. The asset and liability should be reported as such so that the financial statements will be representionally faithful and will display amounts with predictive value are evaluating the future cash flows.

b. & c. are part of the same question. According to the efficient market hypothesis investors would not be fooled by the Mason strategy if they are aware of the net assets of the financing subsidiary. If not, the published financial statement of Mason would contain no details of the lease either in the balance sheet or in the notes. If so, the existence of the asset and associated liability, or knowledge that these are Mason’s asset and liability may not be publicly available. In this case the market may be fooled. c. Mason’s management is clearly attempting to make the financial statements appear as though there is less debt than there really is. The leasing subsidiary arrangement is a sham perpetrated to bias the accounting information. Agency theory predicts that management may be motivated to choose accounting strategies which are aimed at reducing the debt-to-equity ratio. This is particularly true for Mason’s management because of the existence of debt covenants. In my opinion it is unethical for Mason to bias their financial statement to present a more favorable picture, one that does not represent what it purports to represent. It is unethical to try to fool investors or creditors and to make what are in effect false representations of the economic facts e.

No the financing strategy does not provide financial statements that are representationally faithful and unbiased. The strategy is designed to “get around’ debt covenants and bonus 269

agreements. The strategy being employed is similar to what Enron used when it created special purpose entities. The resulting financial statements are not transparent in that they fail to disclose the company’s true financial picture. Case 17-10 a.

It is unethical for Fillups to select an accounting approach because it produces a positive effect on the firm’s financial statements. Financial statements should be reliable. They should be neutral and free from bias. Clearly the Fillups financial statements are not neutral. Neutrality means that in either formulating or implementing accounting standards, the primary concern should be the relevance and reliability of the information being provided, not the effect that the accounting standards will have on a particular interested party. That is, accounting information should be free from bias toward a predetermined result. Neutrality implies that accounting information reports economic activity and financial position as faithfully as possible without attempting to influence behavior in some particular direction. Accounting information that is not neutral loses credibility.

No. Again, to do so would not be neutral. The financial statements would not be free from bias and could be misleading to investors, creditors, and other users. See a. above for a discussion of neutrality

FASB ASC 17-1 Disclosure of Loss Contingency and Subsequent Event The topic of loss contingencies is addressed in FASB ASC 450-20 and. It is accessed by searching ‘contingencies.” Part a. The discussion indicates that the potential loss should be disclosed; however, since no amount is given, the amount of the loss cannot be accrued. Part b Given the FASB ASC 450-20 criteria, the accident generally would not be accrued and reported in the financial statements because it did not occur until after December 31 (post balance sheet). FASB ASC 17-2 Accounting Policies The issue of accounting policy disclosure is contained in section 235-10. It is accessed through the cross reference function and APB Opinion No 22. The EITF information can be found by using the Printer Friendly with sources link after accessing the topic. FASB ASC 17-3 Accounting for Changing Prices Search Changing Prices

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Topic 255-10

FASB ASC 17-4 Interim Financial Reports in the Oil and Gas Industry Search oil and gas and interim reporting Or access through the industry link-extractive industries-oil and gas-interim reporting. 932-270 FASB ASC 17-5 Interim Financial Reports in the Construction Industry Search contractors and accounting policies Or access through the industry link-Construction-Contractors-Disclosure 910-235-50 FASB ASC 17-6 Disclosure of Foreign Activities Access through industry link financial services depository and lending companiesdisclosure 942-235-S99 FASB ASC 17-7 Common Interest Realty Associations Search common interest realty association 972-235 Room for Debate Debate 17-1 Team 1 Argue for recording the lease as a capital lease This is an ethics case. It is unethical to structure the lease so that the company will be able to keep the debt off balance sheet. This is masking the economic facts and results in biased reporting. By paying a third party to guarantee the lease, Snappy is able to circumvent the requirement that the lease be capitalized. In my opinion, self-guarantee is in substance the sale as taking out insurance, i.e., paying a third party to guarantee the lease. In either case, the lessee has taken care of the guarantee of the residual value. In any event the conditions of the lease satisfy the definition of assets and liabilities found in the conceptual framework. SFAC No. 6 defines assets as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. An asset embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to 271

future net assets. A lease embodies the transfer of rights to the lessee to use the leased asset. The use of the asset singly, or in combination with other assets contributes directly or indirectly to generate future cash flows. A particular entity can obtain the benefit derived from an asset or control other’s access to it. The lease transfers rights to use the asset to the lessee who then obtains benefits derived from its use. The transaction or event giving rise to the entity’s right to or control of the asset has already occurred. That transaction is the initiation of the lease agreement. It is clear that a lease agreement has all three characteristics of an asset even when it does not meet the SFAS No. 13 criteria for capitalization as an asset. Similarly, the lease obligates the entity to make future cash payments and meets the definition of a liability. Liabilities are defined by SFAC No. 6 as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. They embody a present duty or responsibility to one or more other entities (in this case to the lessor) that entails settlement by probable future transfer or use of assets at a specified determinable date. The lease payments are set and will entail the payment of assets (cash) to the lessor at specified amounts and dates according to the lease contract. Finally, the transaction or event (the initiation of the lease contract) obligating the entity to make the lease payments has already happened. Since the lease meets the definitions of assets and liabilities, it should be reported as a capital lease. If not, the financial statements will not be reliable. They will not report what they purport to represent. That is they will not be representationally faithful, nor will they be neutral. They will omit information which is have predictive value and is relevant to user decision-making. Finally, it is not reasonable to assume that no one owns the asset. If it is a sale to the lessor, the lessor does not report the asset. If the asset does not belong to the lessor, then it must be the lessee’s asset. Team 2 Argue for treating the lease as an operating lease If the lessee does not guarantee the salvage value then the lessee is not acting as an owner. The lessee is only using the asset temporarily. Rather, the payments to the lessor only represent rent. When the lessee calculates the present value of the minimum lease payments, the third party guarantees of salvage are not included, and the present value thus calculated is not virtually all of the value of the asset. The lessee then treats the lease as an operating lease. The lessee will be following generally accepted accounting principles. The lease criteria found in SFAS No. 13 are intended to be used to determine whether a lease should be capitalized or not. If they do not meet at least one of the four lease criteria, the transaction does not indicate that a purchase of an asset has occurred or that a liability has been incurred. Instead the lease payments are considered a period expense. If none of the lease criteria are met, then the leased asset will revert to the lessor at the end of the lease term. Title to the asset will never have belonged to the lessee. Hence, the lessee has only temporary use or control of the asset and does not meet the definition of an asset. Moreover, the lessee will not have acquired substantially all of the economic 272

benefits to be derived from the leased asset because it is apparent from the facts in the case that the lessee will not derive benefit for virtually all of its useful life (at least 75% thereof). Nor do the amount and timing of the lease payments imply that the lessee is essentially paying for the asset (present value of minimum lease payments at least 90%). The implication of the agreement is that the lessor owns and controls the asset, but is allowing the lessee to use the asset temporarily for a fee, or rent. If the leased asset does not belong to the lessee then payments for its use are merely periodic rent and as such should be treated as rent expense. As such they do not represent payments on a liability. Thus, it would be inappropriate to record a liability for a lease that is not in essence a purchase of an asset. Debate 17-2 Booking the Budget Team 1 In general, APB Opinion No. 28 (FASB ASC 270) supports the integral view of interim reporting. According to the integral view, interim periods are an integral part of the annual period, thus revenues and expenses might be allocated to various interim periods even though they occurred only in one period. The APB noted that interim financial information is essential to provide timely data on the progress of the enterprise and that the usefulness of the data rests on its relationship to annual reports. Accordingly, the Board determined that interim periods should be viewed as integral parts of the annual period and that the principles and practices followed in the annual period should be followed in the interim period. However, certain modifications were deemed necessary in order to provide a better relationship to the annual period. Under APB Opinion No. 28 (FASB ASC 270), costs that are related to revenues should be allocated and matched with revenue in the same manner as the annual report. We argue that Microsoft’s marketing expenditures are related to sales and can be allocated across interim periods so that the results of interim periods better relate to the results of operations reported in the annual report. For example, Microsoft may make marketing expenditures in one accounting period that result in sales of another period. Since no causal relationship can be adequately determined, allocation across accounting periods of the total expected cost (such as those in the budget) would provide a reasonable approximation of the annual results. The above is consistent with cost estimates and allocations that are allowed under APB Opinion No. 28 (FASB ASC 270) . The Opinion APB allows companies to use estimated gross profit rates to estimate and report interim cost of goods sold. It also allows companies to estimate accruals to be made at a later date in an effort to achieve a fair measure of results of operations for the annual period and to present fairly the financial position at the end of the annual period. Allocation of cost that will benefit more than one accounting period is allowed. According to APB Opinion No. 28 (FASB ASC 270) , the amounts of certain costs are frequently subjected to year-end adjustments even though they can be reasonably approximated at interim dates. To the extent possible such adjustments should be estimated and the estimated costs assigned to interim periods so that the interim periods 273

bear a reasonable portion of the anticipated annual amount. Use of budgeted amounts is normally related to sales projections. Hence, we argue that they provide a reasonable estimate of the relationship to annual sales and thus result in the assignment of costs to interim periods that allow the interim reports to bear a reasonable portion of the anticipated annual results. Team 2 We disagree with the interim accounting approach used by Microsoft. We base our arguments on the discrete view of interim reporting. Proponents of the discrete view believe that each interim period should be treated as a separate accounting period in the same manner as the annual period. Thus, the same principles used to report deferrals, accruals, and estimated items in the annual report would also be employed in preparing interim reports. In accordance with the discrete approach, there generally should be no allocation to other interim periods of expenses incurred in one interim period. Instead, Microsoft should have reported all expenses incurred during the accounting period, rather than reporting budgeted expenses. According to APB Opinion 28 (FASB ASC 270), interim information is essential to provide investors and others with timely information as to the progress of the company. The company should apply the same accounting principles and approaches to an interim report that they do for the annual report. Since companies must report cost incurred during the period in their annual report, it follows that the companies should report cost incurred during the interim period in the interim report. Thus use of the discrete approach wherein the actual expenses incurred during the interim period are reported for that period would allow the investor to see what actually occurred during the interim period and thus the real progress toward year end. Costs incurred during an accounting period that cannot be identified with the activities or benefits of other interim periods should be charged to the interim period in which they were incurred. Advertising costs are incurred in hopes of generating company sales. However, no causal relationship between advertising costs and sales can be established. Since the relationship at best can only be assumed, companies should not arbitrarily assign these costs to interim periods. Debate 17-3 Full Disclosure Investors, creditors and other users of financial statements often argue that there should be more transparency in published financial statements. This argument is based, at least to some extent on concerns that management has too much leeway in the selection of accounting alternatives. Team 1:

Argue that management should continue to be allowed to choose among different accounting alternatives because full disclosure in the notes to financial statements provides sufficient transparency.

We argue that management should be allowed to choose among different accounting alternatives. We also believe that full disclosure in the notes combined with the alternatives chosen provide sufficient transparency to allow investors, creditors, and other users to evaluate the company’s financial position as well as its financial performance. 274

The financial statements, footnotes, and supplementary schedules constitute the company’s financial report. And all significant information should be included in the financial report. Additionally, other relevant information, which can assist in understanding the financial report, is presented in narrative form. Examples of these types of items are management’s discussion and analysis and the letter to stockholders. The footnotes to a company’s financial statements provide a significant amount of additional information about the items on the company’s financial statements. In general, the footnotes disclose information that explains, clarifies, or develops items appearing on the financial statements, which cannot easily be incorporated into the financial statements themselves. The most common examples of footnotes are: 1. Accounting policies 2. Schedules and exhibits—Firms typically report schedules or exhibits concerning longterm debt and income tax, for example. 3. Explanations of financial statement items—Some items require additional explanation so that users can make sense of the reported information. Pensions and postretirement benefits are two examples. 4. General information about the company—Occasionally, firms face events that may impact their financial performance or position but cannot yet be recognized on the financial statements. In that case, investors have an interest in learning this information as soon as possible. Information concerning subsequent events and contingencies are two examples. The purpose of supplementary schedules is to improve the understandability of the financial statements. They may be used to highlight trends, such as five-year summaries; or they may be required by FASB pronouncements, such as information on current costs. The SEC recently announced a proposed rule requiring additional disclosures that are designed to improve the transparency of companies’ financial disclosure. These new disclosures would enhance investors’ understanding of the application of companies’ critical accounting policies. The proposals encompass disclosure in two areas: accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of the proposal, a company would identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation. Disclosure about those estimates would then be required if different estimates that the company reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations. A company’s disclosure about these critical accounting estimates would include a discussion of the methodology and assumptions underlying them; the effect the accounting estimates have on the company’s financial presentation; and the effect of changes in the estimates. Under the second part of the proposal, a company that has initially adopted an accounting policy with a material impact would be required to disclose information that indicates 275

what gave rise to the initial adoption; the impact of the adoption; the accounting principle adopted and method of applying it; and the choices it had among accounting principles. Companies would place all of the new disclosure in the MD&A section of their annual reports, registration statements, and proxy and information statements. In addition, companies would be required to update the information regarding their critical accounting estimates to disclose material changes. Current accounting practice requires full disclosure of accounting changes and their impact on the company’s financial statements. If the accounting procedures and policies are clearly disclosed in the notes, management should continue to be able to choose that method that is most appropriate for the company. Also, disclosure of the accounting procedures and policies should enable financial analysts to make adjustments that allow him/her to compare a company over time and to compare one company with another. Some have argued that full disclosure of risk, various debt instruments, and lease obligations provides more meaningful information than does the way these items are accounted for on the balance sheet. Finally, one shoe does not fit all. Straight-line depreciation may provide a better way to allocate cost for some companies while an accelerated method may be appropriate for another. Doing away with management’s ability to pick and choose among the various accounting alternatives that are currently available to choose from it likely to narrow the scope for individual thought and judgment. It is wrong to assume that all accounting choices are made to manage earnings or to manipulate what is reported in financial statements. Team 2: Argue that there should be a narrowing of accounting alternatives because full disclosure in the notes is not sufficient to curb potential management abuses.

We disagree that companies should be allowed to arbitrarily pick and choose which accounting approaches they wand and we do not believe that full disclosure in the notes is sufficient to allow for transparency of what is reported and thereby reduce the need to narrow the number of accounting alternatives. Under the Conceptual Framework, the most relevant information should always appear in one of the financial statements, provided that it meets the SFAC No. 5 criteria for measurement and recognition. Conversely, we believe that there should be a narrowing of accounting alternatives because full disclosure in the notes is not sufficient to curb potential management abuses. We believe that management should not be allowed to select an accounting alternative solely on the basis of its financial statement effect. The myriad requirements for full disclosure did not stop companies have not stopped management from managing earnings and even committing fraud – note the behavior of WorldCom and Enron. The Conceptual Framework states that reliable financial information is free from bias. Clearly the more accounting alternatives that management has to choose from, the greater the temptation and occurrence of earnings management and other forms of financial statement manipulations. 276

Not only is greater standardization more consistent with freedom from bias, it also results in another desirable characteristic, comparability. According to the Conceptual Framework, useful information should not only be relevant and reliable, it should also provide comparability for one company over time and among companies. The selection of one accounting approach over another can have a material impact on the measurement of amounts reported in financial statements. For example, LIFO and FIFO can result in significantly different values reported in the balance sheet and income statement. LIFO inventory values can severely understate a company’s current assets while producing a significantly lower net income than FIFO or even weighted-average inventory values. Therefore the use of different methods causes confusion among the readers of financial statements and prevents meaningful comparison of statements of different companies. There is strong support in the profession for narrowing the areas of differences in accounting. Reduction in the number of alternatives may narrow the differences and thus lead to more comparability. We argue, the very purpose of GAAP is to narrow the range of acceptable accounting alternatives. Conceptual framework is intended to provide guidance to help the FASB select appropriate principles and rules of measurement and recognition. Furthermore, SFAC No. states that the Conceptual Framework should also provide a frame of reference for resolving accounting questions in the absence of a specific promulgated standard. Determine bounds for judgment in preparing financial statements. The result should be enhanced comparability WWW Case 17-11 a. The company should report its quarterly results as if each interim period is an integral part of the annual period. b. The company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2014 fiscal year: Sales revenue $ 60,000 Cost of goods sold 36,000 Variable selling expenses 1,000,000 Fixed selling expenses Advertising ($2,000,000 ÷ 4) 500,000 Other ($3,000,000 – $2,000,000) 1,000,000 Sales revenue and cost of goods sold receive the same treatment as if this were an annual report. Costs and expenses other than product costs should be charged to expense in interim periods as incurred or allocated among interim periods. Consequently, the variable selling expense and the portion of fixed selling expenses not related to the television advertising should be reported in full. One-fourth of the television advertising is reported as an expense in the first quarter, assuming TV advertising is constant throughout the year. These costs can be deferred within the fiscal period if the benefits of the expenditure clearly extend beyond the interim period in which the expenditure is made. 277

c. The financial information to be disclosed to its stockholders in its quarterly reports as a minimum includes: 1. 2. 3. 4. 5. 6. 7. 8.

Sales revenue or gross revenues, provision for income taxes, extraordinary items (including tax effects), and net income. Basic and diluted earnings per share. Seasonal revenue, costs or expenses. Significant changes in estimates or provisions for income taxes. Disposal of a component of a business and extraordinary, unusual, or infrequently occurring items. Contingent items. Changes in accounting principles or estimates. Significant changes in financial position.

Case 17-12 a. The Securities and Exchange Commission (SEC) is an independent federal agency that receives its authority from federal legislation enacted by Congress. The Securities and Exchange Act of 1934 created the SEC. b. As a result of the Securities and Exchange Act of 1934, the SEC has legal authority relative to accounting practices. The U.S. Congress has given the SEC broad regulatory power to control accounting principles and procedures in order to fulfill its goal of full and fair disclosure. c. There is no direct relationship as the SEC was created by Congress and the Financial Accounting Standards Board (FASB) was created by the private sector. However, the SEC historically has followed a policy of relying on the private sector to establish financial accounting and reporting standards known as generally accepted accounting principles (GAAP). The SEC does not necessarily agree with all of the pronouncements of the FASB. In cases of unresolved differences, the SEC rules take precedence over FASB rules for companies within SEC jurisdiction Case 17-13 The solution to this case requires a visit to the SEC’s home page at the time the case is assigned. Case 17-14 The answer depends on the companies selected. Case 17-15 The answer depends on the companies selected. Financial Analysis Case The answer depends on the companies selected. 278

Chapter 1 WWW Cases Case 1-8 Evolution of Accounting Standards The authority to issue accounting pronouncements has evolved overtime. a. Discuss the rule making bodies involved in issuing accounting pronouncements since the 1930s. b. SEC Accounting Series Release (ASR No. 4) allowed accounting principles to be set in the private sector. ASR No. 4 also indicated that reports filed with the SEC must be prepared in accordance with accounting principles that have “substantial authoritative support.” Define substantial authoritative support. c. How are accounting standards enforced? Case 1-9 Politicization of GAAP Some accountants have said that politicization in the development and acceptance of generally accepted accounting principles (i.e., rule-making) is taking place. Some use the term “politicization” in a narrow sense to mean the influence by governmental agencies, particularly the Securities and Exchange Commission, on the development of generally accepted accounting principles. Others use it more broadly to mean the compromise that results when the bodies responsible for developing generally accepted accounting principles are pressured by interest groups (SEC, American Accounting Association, businesses through their various organizations, Institute of Management Accountants, financial analysts, bankers, lawyers, and so on). Required: a. The Committee on Accounting Procedure of the AICPA was established in the mid- to late 1930s and functioned until 1959, at which time the Accounting Principles Board came into existence. In 1973, the Financial Accounting Standards Board was formed and the APB went out of existence. Do the reasons these groups were formed, their methods of operation while in existence, and the reasons for the demise of the first two indicate an increasing politicization (as the term is used in the broad sense) of accounting standard-setting? Explain your answer by indicating how the CAP, the APB, and the FASB operated or operate. Cite specific developments that tend to support your answer. b. What arguments can be raised to support the “politicization” of accounting rulemaking? c. What arguments can be raised against the “politicization” of accounting rule-making? Case 1-10 International Issues Many companies have a significant amount of sales in foreign markets. Required: 1

Compare the current period sales and net income from U.S. and non-U.S. sales for the following companies. Note any significant differences between the companies. Financial statements can be located on the company websites given. Which company has the largest portion of its sales in the United States? Which has the largest portion of its profits in the United States? Company Ford Motor Company General Motors Corporation Case 1-11 International Accounting Standards Microsoft Corporation presents its income statement in a variety of formats using both the currencies and the accounting practices of other countries in the “Analysis Tools” area of the investor section of their website (www.microsoft.com/msft/tools.htm). Compare the U, S., Canadian, UK, and Australian income statements. What features of the non-U.S. statements do you think are improvements on the U.S. statements? What features did you find to be confusing? Financial Analysis Case Each chapter contains a financial analysis case. For each of these cases, you will be asked to apply some of the principles of financial analysis that were introduced in the various chapters. For Chapter 1 the first assignment is to pick a company to analyze for the entire semester. It is suggested that you choose a Fortune 500 manufacturing or merchandising company so that all of the ratios discussed in subsequent chapters can be calculated. Required: After choosing your company, log onto the SEC Edgar Form Pick website (http://www.sec.gov/edaux/formlynx.htm). Type your company name in the company name box and find the latest 10-K report for the company you have selected. Answer the following questions: What is the company’s conformed name? What is the company’s standard industrial classification? What is the company’s state of incorporation? What is the company’s fiscal year-end? What is the company’s business address? What is the company’s telephone number? On which stock exchange(s) is the company’s stock listed? Summarize the company’s business operations as discussed on the Cover Page in part I of the company’s 10-K. i. Who are the company’s major competitors? (Found under competitive position in part j. Choose two of the company’s competitors to use for comparative analysis purposes and print the latest 10-K reports for these two companies. You will need these reports for the cases in each of the remaining chapters. a. b. c. d. e. f. g. h.

Chapter 2 WWW Cases Case 2-8 The FASB’s Conceptual Framework Discuss the structure of the FASB’s conceptual framework for financial accounting and reporting. Case 2-9 SFAC No. 8 Chapter 3 of SFAC No. 8 identifies the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes. Required: List and briefly describe these qualitative characteristics. Case 2-10 FASB Exposure Drafts and Emerging Issues Visit the FASB's home page on the World Wide Web (http://www.rutgers.edu/Accounting/raw/fasb/welcome.htm). Required: a. Review recently posted FASB Documents and Information to determine if any important new initiatives are being considered by the FASB. b. What exposure drafts are currently outstanding? c. What issues are being considered by the Emerging Issues Task Force? Case 2-11 the FASB’s Mission and Processes Visit the FASB's home page on the World Wide Web (http://www.rutgers.edu/Accounting/raw/fasb/welcome.htm). Review the “FASB Facts” section of its website. In particular, read through the sections “Facts about FASB—Mission & Structure of the Board” and “FASAC—Financial Accounting Standards Advisory Council.” Required: a. Summarize the mission of the FASB in one or two paragraphs. What do you think about the FASB’s mission? Is it too broad; is it too vague, do you think the mission is achievable? b. How effective do you think the FASB’s processes are? Do you think they will focus on the right issues on a timely basis? Do you think that all relevant parties will be heard in their process? c. Summarize the current membership of the FASAC including the group’s mix of 3

gender and type of organization they represent. Do you think this group is adequately diverse in order to allow all relevant parties to be heard? Case 2-12 FASB Recent Additions Visit the FASB's home page on the World Wide Web (http://www.fasb.org/) Required: Review the “Recent Activity and News” section of the FASB website. Pick two of the items presented and (1) summarize the items and (2) provide your own opinion about the items and how you think the FASB should handle any issues that are presented. Case 2-13 Principles Based vs. Rule Based Accounting Standards Required: Discuss the issue of principles based vs. rule based accounting standards. Case 2-14 International Accounting standards Required: Discuss the FASB-IASB international convergence project Case 2-15 The Financial statement Presentation Project Required: Discuss the FASB-IASB financial statement presentation project. Case 2-16 The Conceptual Framework Project On October 2004, the FASB and IASB decided to add to their agendas a joint project to develop an improved and common conceptual framework that is based on and builds on their existing frameworks. Required: a. What is the goal of this project? b. List and discuss the eight phases of this project. Case 2-17 Conceptual Framework The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties. The purpose of the statement on qualitative characteristics is to examine the characteristics 4

that make accounting information useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made. Required: a. Identify and discuss the benefits that can be expected to be derived from the FASB's conceptual framework study. b. What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important. c. Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for financial reporting purposes. Financial Analysis Case Companies disclose the impact of new accounting pronouncements in the footnotes to their financial statements (Usually in the Summary of Significant Accounting Policies). Required: Search your company’s financial statements to determine the new accounting standards that affected their operations during the past year and summarize their effects. Chapter 3 WWW Cases Case 3-7 Use of Form 20-F In 2007, the SEC modified its position on the Form 20-F requirement when it issued; “Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to GAAP.” This rule amends Form 20-F to accept from foreign private issuers in their filings with the SEC financial statements prepared in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board without reconciliation to generally accepted accounting principles as used in the United States. Required: a. What was the SEC’s rationale for this decision? b. How did the American Accounting Association respond to the SEC proposal? Case 3-8 IASB vs. FASB Conceptual Frameworks Discuss the similarities and differences between the FASB and IASB conceptual frameworks with respect to the definitions of the elements of financial statements. Case 3-9 IASC Home Page 5

Log onto the World Wide Web and enter the International Accounting Standards Board's home page. Required: a. What general categories of information are contained on the IASB's home page? b. What current issues is the IASB reviewing? Financial Analysis Case GAAP vs. International Accounting Standards Required: Find a foreign company that is selling securities in the U.S. securities markets and comment on the change in net income that was caused by changing from the company’s domestic accounting standards to U.S. GAAP. Chapter 4 WWW Cases Case 4-10 Agency Theory According to agency theory, the existence of debt imposes agency costs. Required: a. What are agency costs? b. Explain why an increase in debt would increase agency costs and what the resulting effect would be for debt holders. c. What strategy might debt holders utilize to counter potential adverse agency effects? Case 4-11 Fundamental Analysis What is fundamental analysis and what is its goal? Case 4-12 Capital Asset Pricing Model Log onto the World Wide Web and find three companies whose stocks are traded on the New York Stock Exchange. Compute a beta for the three companies by comparing the movement in their stock with the movement of Standard and Poor's 500 for five years. (For simplicity, track the percentage stock returns and the percentage return for the index on the first day of each quarter for the five-year period.) Hint: You can compute beta by using each of the company's quarterly returns as the dependent variable and the index as the independent variable in a regression analysis. Compare the betas of the three companies. What do these betas tell you about the relative volatility of the three stocks? Next, compute the betas for the three companies using the movement in the Dow Jones Industrials over the same period. Are the calculated betas the same? Why? Finally, look the companies in an investor service such as Value Line or Standard and Poor’s. What are the betas disclosed for the companies? 6

Financial Analysis Case Compile information for your company to be used to perform a fundamental analysis (annual reports, quarterly reports, management’s discussion and analysis and information from the financial press). Required: a. Consult the Web to determine the current recommendation for your company’s stock from financial analysts. (A good source for this information is the Fortune Investor.) b. Comment on the trend in earnings for your company and future expectations voiced by management. c. Chart your company’s stock price for the past 12 months and compare it to changes in the Standard and Poor’s Index (Use another index if your company is in a specialized industry for which an index is published.) d. Use the index chosen in part c to compute a beta for your company. Chapter 5 WWW Cases Case 5-9 Revenue Recognition In the precious metal industry, revenue may be recognized when a precious metal is mined and refined. Required: a. Describe how this practice differs from the way companies typically recognize revenue. b. Explain the reasoning behind recognizing revenue when a precious metal is mined and refined. c. Explain the reasoning behind the typical practice for recognizing revenue. Case 5-10 Alternative Method of Revenue Recognition Nextor Industries has three operating divisions—Extracta Mining, Softcover Paperbacks, and Burgler Protection Devices. Each division maintains its own accounting system and method of revenue recognition. Extracta Mining Extracta Mining specializes in the extraction of precious metals such as silver, gold, and platinum. During the fiscal year ended November 30, 2014, Extracta entered into contracts worth $2,250,000 and shipped metals worth $2,000,000. A quarter of the shipments were made from inventories on hand at the beginning of the fiscal year, and the remainder were made from metals that were mined during the year. Mining totals for the year, valued at market prices, were silver at $750,000, gold at $1,400,000, and platinum at $490,000. Extracta uses the completion-of-production method to recognize revenue because its operations meet the specified criteria, i.e., reasonably assured sales prices, interchangeable units, and insignificant distribution costs. 7

Softcover Paperbacks Softcover Paperbacks sells large quantities of novels to a few book distributors that in turn sell to several national chains of bookstores. Softcover allows distributors to return up to 30% of sales, and distributors give the same terms to bookstores. While returns from individual titles fluctuate greatly, the returns from distributors have averaged 20% in each of the past 5 years. A total of $7,000,000 of paperback novel sales were made to distributors during the fiscal year. On November 30, 2014, $2,200,000 of fiscal 2014 sales were still subject to return privileges over the next 6 months. The remaining $4,800,000 of fiscal 2014 sales had actual returns of 21%. Sales from fiscal 2014 totaling $2,500,000 were collected in fiscal 2014, with less than 18% of sales returned. Softcover records revenue according to the method referred to as revenue recognition when the right of return exits, because all applicable criteria for use of this method are met by Softcover's operations. Burgler Protection Devices Burgler Protection Devices works through manufacturers' agents in various cities. Orders for alarm systems and down payments are forwarded from agents, and Burgler ships the goods f.o.b. shipping point. Customers are billed for the balance due plus actual shipping costs. The firm received orders for $6,000,000 of goods during the fiscal year ended November 30, 2014. Down payments of $600,000 were received, and $5,000,000 of goods were billed and shipped. Actual freight costs of $100,000 were also billed. Commissions of 10% on product price were paid to manufacturers' agents after the goods were shipped to customers. Such goods are warranted for 90 days after shipment, and warranty returns have been about 1% of sales. Revenue is recognized at the point of sale by Burgler. Required: a. There are a variety of methods for revenue recognition. Define and describe each of the following methods of revenue recognition, and indicate whether each is in accordance with generally accepted accounting principles. 1. Completion-of-production method. 2. Percentage-of-completion method. 3. Installment-sales method. b. Compute the revenue to be recognized in the fiscal year ended November 30, 2014, for 1. Extracta Mining. 2. Softcover Paperbacks. 3. Burgler Protection Devices. Case 5-11 Revenue Recognition Fitness Health and Racquet Club (FHRC) operates eight clubs in the Phoenix, Arizona area, and offers one-year memberships. The members may use any of the eight facilities but must reserve racquetball court time and pay a separate fee before using the court. As an incentive to new customers, FHRC advertised that any customers not satisfied for any reason could receive a refund of the remaining portion of unused membership fees. Membership fees are due at the beginning of the individual membership period. However, customers are given the option of financing the membership fee over the membership period at a 9% interest rate. Some customers have expressed a desire to take only the regularly scheduled aerobic classes without paying for a full membership. During the current fiscal year, FHRC began selling 8

coupon books for aerobic classes to accommodate these customers. Each book is dated and contains 50 coupons that may be redeemed for any regularly scheduled aerobics class over a one-year period. After the one-year period, unused coupons are no longer valid. During 2012, FHRC expanded into the health equipment market by purchasing a local company that manufactures rowing machines and cross-country ski machines. These machines are used in FHRC's facilities and are sold through the clubs and mail order catalogs. Customers must make a 20% down payment when placing an equipment order; delivery is 60–90 days after order placement. The machines are sold with a 2-year unconditional guarantee. Based on past experience, FHRC expects the costs to repair machines under guarantee to be 4% of sales. FHRC is in the process of preparing financial statements as of June 30, 2014, the end of its fiscal year. Robbie Rivera, corporate controller, expressed concern over the company's performance for the year and decided to review the preliminary financial statements prepared by JoEllyn Els, FHRC's assistant controller. After reviewing the statements, Rivera proposed that the following changes be reflected in the June 30, 2014, published financial statements: 1. Membership revenue should be recognized when the membership fee is collected. 2. Revenue from the coupon books should be recognized when the books are sold. 3. Down payments on equipment purchases and expenses associated with the guarantee on the rowing and cross-country machines should be recognized when paid. Els indicated to Rivera that the proposed changes are not in accordance with generally accepted accounting principles. Required: a.. Discuss when Fitness Health and Racquet Club (FHRC) should recognize revenue from membership fees, court rentals, and coupon book sales. b. Discuss how FHRC should account for the down payments on equipment sales, explaining when this revenue should be recognized. c. When should FHRC recognize the expense associated with the guarantee of the rowing and cross-country machines? Case 5-12 Repo 105 Discuss Repo105 accounting. Case 5-13 Presentation of Comprehensive Income Log on to the World Wide Web and search for the annual reports of three domestic "Fortune 1000" companies and three international companies. Required: a. Review the income statements of the three domestic companies i. Do the companies disclose items of other comprehensive income as defined by the FASB? ii. For companies disclosing items of other comprehensive income, is a one statement or two statement approach used to disclose these items? 9

b. Review the income statements of the three international companies. Do the companies present a Statement of Non-owner Movements in Equity? Case 5-14 Revenue and Expense Recognition Principles On August 10, 2013, Lockeed Corporation signed a contract with Olasabel Inc. under which Olasabel agreed (1) to construct an office building on land owned by Lockeed, (2) to accept responsibility for procuring financing for the project and finding tenants, and (3) to manage the property for 35 years. The annual net income from the project, after debt service, was to be divided equally between Lockeed Corporation and Olasabel Associates. Olasabel was to accept its share of future net income as full payment for its services in construction, obtaining finances and tenants, and management of the project. By June 30, 2014, the project was nearly completed, and tenants had signed leases to occupy 90% of the available space at annual rentals totaling $4,000,000. It is estimated that, after operating expenses and debt service, the annual net income will amount to $1,500,000. The management of Olasabel Inc. believed that (a) the economic benefit derived from the contract with Lockeed should be reflected on its financial statements for the fiscal year ended June 30, 2014, and directed that revenue be accrued in an amount equal to the commercial value of the services Olasabel had rendered during the year, (b) this amount should be carried in contracts receivable, and (c) all related expenditures should be charged against the revenue. Required: a. Explain the main difference between the economic concept of business income as reflected by Olasabel's management and the measurement of income under generally accepted accounting principles. b. Discuss the factors to be considered in determining when revenue should be recognized for the purpose of accounting measurement of periodic income. c. Is the belief of Olasabel's management in accordance with generally accepted accounting principles for the measurement of revenue and expense for the year ended May 31, 2014? Support your opinion by discussing the application to this case of the factors to be considered for asset measurement and revenue and expense recognition. Case 5-15 Expense Recognition Principle An accountant must be familiar with the concepts involved in determining earnings of a business entity. The amount of earnings reported for a business entity is dependent on the proper recognition, in general, of revenue and expense for a given time period. In some situations, costs are recognized as expenses at the time of product sale. In other situations, guidelines have been developed for recognizing costs as expenses or losses by other criteria. Required: a. Explain the rationale for recognizing costs as expenses at the time of product sale. b. What is the rationale underlying the appropriateness of treating costs as expenses of a period instead of assigning the costs to an asset? Explain.

c. In what general circumstances would it be appropriate to treat a cost as an asset instead of as an expense? Explain. d. Some expenses are assigned to specific accounting periods on the basis of systematic and rational allocation of asset cost. Explain the underlying rationale for recognizing expenses on the basis of systematic and rational allocation of asset cost. e. Identify the conditions under which it would be appropriate to treat a cost as a loss. Case 5-16 Accounting for Pollution Penalty Global Warming Company operates several plants at which limestone is processed into quicklime and hydrated lime. The Smokey Haze plant, where most of the equipment was installed many years ago, continually deposits a dusty white substance over the surrounding countryside. Citing the unsanitary condition of the neighboring community of Hazelcrest, the pollution of the Rock River, and the high incidence of lung disease among workers at Smokey Haze, the state's Pollution Control Agency has ordered the installation of air pollution control equipment. Also, the agency has assessed a substantial penalty, which will be used to clean up Hazelcrest. After considering the costs involved (which could not have been reasonably estimated prior to the agency's action), Global Warming Company decides to comply with the agency's orders, the alternative being to cease operations at Smokey Haze at the end of the current fiscal year. The officers of Global Warming agree that the air pollution control equipment should be capitalized and depreciated over its useful life, but they disagree over the period(s) to which the penalty should be charged. Required: Discuss the conceptual merits and reporting requirements of accounting for the penalty in each of the following: a. As a charge to the current period. b. As a correction of prior periods. c. As a capitalizable item to be amortized over future periods. Financial Analysis Case Assess your company’s quality of earnings. Required: a. Use the eight techniques outlined in the text. b. Assess the correlation between accounting income and economic income for your company. Chapter 6 WWW Cases Case 6-10 Objectives of Financial Statements 11

Discuss how a company’s primary financial statements are useful to potential investors who are trying to decide whether to buy stock in the company. Support your discussion by citing objectives outlined in the Conceptual Framework. Case 6-11 Classification of Income Statement Items You are in charge of reviewing the classification of unusual items that have occurred during for your CPA firm during the current year. The following material items have come to your attention: 1. A department store incorrectly overstated its ending inventory 2 years ago. Inventory for all other periods is correctly computed. 2. An automobile dealer sells for $137,000 an extremely rare antique automobile which it purchased for $21,000 10 years ago. The antique auto is the only similar item the dealer owns. 3. An oil company during extended the estimated useful life of certain drilling equipment during the current year from 8 to 12 years. As a result, depreciation for the current year was materially lowered. 4. A discount outlet changed its computation for bad debt expense from 1% to of 1% of sales because of changes in its customer clientele. 5. A mining company sells a foreign subsidiary engaged in uranium mining, although it (the seller) continues to engage in uranium mining in other countries. 6. A grocery store chain changes from the average cost method to the FIFO method for inventory costing purposes. 7. A construction company, at great expense, prepared a major proposal for a government loan. The loan is not approved. 8. A manufacturer has had large losses resulting from a strike by its employees early in the year. 9. Depreciation for a prior period was incorrectly understated by $2,000,000. The error was discovered in the current year. 10. A chicken farm suffered a major loss because the state required that all chickens in the state be killed to halt the spread of bird flu. Such a situation has not occurred in the state for 20 years. 11. A food processor that sells wholesale to supermarket chains and to fast-food restaurants (two distinguishable classes of customers) decides to discontinue the division that sells to one of the two classes of customers. Case 6-12 Format of Proposed Income Statement In Phase B of the joint FASB-IASB financial statement presentation project, the Boards are planning to release a plan to recast financial statements into a new format. One possible result is the elimination of the current definition of net income. In its place, financial statement users may find a number of profit figures that correspond to different corporate activities. Required: 12

Discuss the proposed new format of the income statement. Case 6-13 Using Judgment in Applying Accounting Policies IAS No. 8 states that when a Standard or an Interpretation specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item must be determined by applying the Standard or Interpretation and considering any relevant implementation guidance issued by the IASB for the Standard or Interpretation. However, in the absence of a Standard or an Interpretation that specifically applies to a transaction, judgment should be used in developing and applying an accounting policy that results in information that is relevant and reliable. Required: Discuss the sources to be considered when making that decision. Case 6-14 IAS No. 1 The IASB outlined its requirements for the presentation of the income statement in IAS No. 1, “Framework for the Preparation and Presentation of Financial Statements” Required: a. What is the objective of IAS No. 1? b. What income information does IAS No. 1 required to be presented? c. What are the allowable methods for presenting that information? Case 6-15 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Required: a. Review the income statements for the three domestic companies and answer the following questions for the last reporting year: i. What income statement format does each company use? ii. What are the basic and diluted earnings per share for each company? iii. Have any of the companies disclosed accounting changes? iv. Have the companies reported any discontinued operations for the last year? b. Review the income statements for the three domestic companies and answer the following questions for the last reporting year: i. Do the companies present the income statement in the format suggested in Presentation of Financial Statements? ii. What are the basic and diluted earnings per share for each company? iii. Have any of the companies disclosed accounting changes? iv. Have the companies reported any discontinued operations for the last year? 13

Financial Analysis Case Assess investors’ comparative perceptions of the outlook for your company. Required: a. Compute the price/earnings ratio for your company and its two competitors for the last day of its latest fiscal year. b. Comment on the implications of your company’s price/earnings ratio in comparison to its competitors’ and market averages. Chapter 7 WWW Cases Case 7-9 Assets, Liabilities, Gains and Losses A company is required to report a liability in its balance sheet when it expects to lose a law suit and the amount of the expected loss can be reasonably estimated. Conversely, a company is prohibited from reporting a receivable in its balance sheet when it expects to win a lawsuit even though it is probably and the amount of the expected gain can be reasonably estimated. Required: a. Does the expected loss meet the definition of a liability found in the conceptual framework? Explain. b. Does the expected gain meet the definition of an asset found in the conceptual framework? Explain. c. Why do you think accountants treat these seemingly similar situations differently? Explain. Case 7-10 Fair Value Measurements Required: a. Summarize SFAS No. 157 “Fair Value Measurements b. Later, FSP FAS 157-4 was issued to provide guidance on how to determine when the volume and level of activity for an asset or liability has significantly decreased and identified the circumstances in which a transaction is not orderly. List the factors specified that indicate there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity. c. Subsequently, after considering the significance and relevance the above or other factors, judgment is to be used to determine whether the market is active, and if a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value. List the circumstances identified by FSP FAS 157-4 that may indicate that a transaction is not orderly.

Case 7-11 Statement of Cash Flows The following Statement of Cash Flows was prepared for the Baines Corporation. Baines Corporation Statement of Sources and Uses of Cash Year Ended December 31, 2014 Sources of cash Net income Depreciation and depletion Increase in long-term debt Changes in current receivables and inventories, less current liabilities

$111,000 70,000 179,000 14,000 $374,000

Uses of cash Cash dividends $ 60,000 Expenditure for property, plant, and equipment 214,000 Investments and other uses 20,000 Change in cash 80,000 The following additional information relating to Baines Corporation is available for the year ended December 31, 2014. 1. Wage and salary expense attributable to stock option plans was $25,000 for the year. 2. Expenditures for property, plant, and equipment $250,000 Proceeds from retirements of property, plant, and equipment 36,000 Net expenditures $214,000 3. A stock dividend of 10,000 shares of Baines Corporation common stock was distributed to common stockholders on April 1, 2014, when the per share market price was $7 and par value was $1. 4. On July 1, 2014, when its market price was $6 per share, 16,000 shares of Baines Corporation common stock were issued in exchange for 4,000 shares of preferred stock. 5. Depreciation expense $ 65,000 Depletion expense 5,000 $ 70,000 6. Increase in long-term debt $620,000 Retirement of debt 441,000 Net increase $179,000 Required: a.

In general, what are the objectives of a statement of the type shown above for Baines Corporation? Explain

Indentify the weaknesses in the form and format of Baines Corporation's statement of cash flows without reference to the additional information. (Assume adoption of the indirect method.)

For each of the six items of additional information for the statement of cash flows, indicate the preferable treatment and explain why the suggested treatment is preferable.

CASE 7-12 Format of Proposed Statement of Financial Position In Phase B of the joint FASB-IASB financial statement presentation project, the Boards are planning to release a plan to recast financial statements into a new format. The proposed new format of the statement of financial position would no longer divide assets and liabilities into separate categories on the balance sheet; rather, it groups assets and liabilities together under the categories of operating, investing, and financing activities while continuing to provide a separate section for stockholders’ equity. Required: Discuss the proposed new format of the statement of financial position Case 7-13 Analysis of Financial Statements Log on to the World Wide Web and search for the annual reports of three domestic "Fortune 1000" companies and three international companies. Required: a. Review the balance sheets and statements of cash flows for the three domestic companies and answer the following questions for the last reporting year: i. What are some of the measurement bases used by the companies to report their assets? ii. Did the companies pay dividends for the last reporting year? iii. What method of reporting cash flows from operating activities did each of the companies use? iv. What were the company's cash flow from operations? Did this differ substantially from the net income reported on the income statement? Why? v. What were the company's major cash flows from investing and financing activities? b. Review the balance sheets and statements of cash flows for the three international companies and answer the following questions for the last reporting year: i. What are some of the measurement bases used by the companies to report their assets? ii. Did the companies pay dividends for the last reporting year? iii. Are the companies disclosing the information concerning their financial assets that is required under the provisions of IAS No. 32? 16

iv. v. vi. vii.

What method of reporting cash flows from operating activities did each of the companies use? What were the company's cash flow from operations? Did this differ substantially from the net income reported on the income statement? Why? What were the company's major cash flows from investing and financing activities? Do the companies follow U.S. GAAP or international standards in reporting cash flows from investing activities?

Case 7-14 Presentation of Comprehensive Income Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Required: a. Review the income statements of the three domestic companies: i. Do the companies disclose items of other comprehensive income as defined by the FASB? ii. For companies disclosing items of other comprehensive income, is a one-statement or two-statement approach used to disclose these items? b. Review the income statements of the three international companies. Do the companies present a Statement of Non-owner Movements in Equity? Financial Analysis Case Assess the financial position of your company in comparison to its competitors Required: a. Compute the return on assets, profit margin and asset utilization rate for your company and its two competitors. b. Assess your company’s competitive financial position. c. Compute the free cash flow for your company and its two competitors d. Assess your company’s relative cash position and comment on its receipt and use of cash during the year. Chapter 8 WWW Cases Case 8-12 Inventoriable Costs Frank Holland, an inventory control specialist, is interested in better understanding the accounting for inventories. Although Frank understands the more sophisticated computer inventory control systems, he has little knowledge of how inventory cost is determined. In studying the records of Zippy Enterprises, which sells normal brand-name goods from its own store and on consignment through Touk Inc., he asks you to answer the following questions. Required:

a. Should Zippy Enterprises include in its inventory normal brand-name goods purchased from its suppliers but not yet received if the terms of purchase are f.o.b. shipping point (manufacturer's plant)? Why? b. Should Zippy Enterprises include freight-in expenditures as an inventory cost? Why? c. If Zippy Enterprises purchases its goods on terms 2/10, net 30, should the purchases be recorded gross or net? Why? d. What are products on consignment? How should they be reported in the financial statements? Case 8-13 Accounting for Purchase Discounts Companies record purchases of inventory on account having terms that allow cash discounts under either the net method or the gross method. The net method is generally considered theoretically sounder than the gross method. Required: Describe the advantages and disadvantages of both methods. Case 8-14 Accounting for Inventory U. S. GAAP and international accounting standards currently differ on some aspects of inventory accounting.\ Required: Discuss these differences. Case 8-15 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Required: a. Review the balance sheets for the three domestic companies and answer the following questions for the last reporting year: i. Do the companies disclose any short-term investments? If so, what method is used to account for these short-term investments? ii. What inventory cost flow methods are the companies using? iii. Compute the working capital for each of the companies. b. Review the balance sheets for the three international companies and answer the following questions for the last reporting year: i. Do the companies separately disclose current assets and current liabilities? ii. Do the companies disclose any short-term investments? If so, what method is used to account for these short-term investments? 18

iii. What inventory cost flow methods are the companies using? iv. Compute the working capital for each of the companies. Financial Analysis Case Evaluate your company’s working capital position. Required: a. Compute the following ratios for your company and its two competitors: i. Working capital ii. Current ratio iii. Acid test ratio iv. Cash flow from operations to current liabilities v. Accounts receivable turnover ratio vi. Days in receivables vii. Inventory turnover ratio viii. Average days in inventory b. Assess the relative working capital position of your company. Chapter 9 WWW Cases Case 9-12 Impairment of Assets Long-term fixed assets are written down when it is determined that they have been impaired. Required: a. When are assets considered impaired under current GAAP? b. How are impairment losses measured under current GAAP? c. Would it be more or less conservative to measure the loss using the recoverable amount to measure impairment losses? Explain. d. Which would be more consistent with economic income: measuring impairment losses using the recoverable amount or the measurement required under current GAAP? Explain. Case 9-13 Capitalization of Interest Watson Airline is converting from piston-type planes to jets. Delivery time for the jets is 3 years, during which time substantial progress payments must be made. The multimilliondollar cost of the planes cannot be financed from working capital; Watson must borrow funds for the payments. Because of high interest rates and the large sum to be borrowed, management estimates that interest costs in the second year of the period will be equal to one-third of income before interest and taxes, and one-half of such income in the third year. After conversion, Watson's passenger-carrying capacity will be doubled with no increase in the number of planes, although the investment in planes would be substantially increased. The jet planes have a 20-year service life. 19

Required: Discuss the proper accounting for interest during the conversion period. Support your recommendation with reasons and suggested accounting treatment. (Disregard income tax implications.) 9-14 International Property, Plant and Equipment Standard The revised IAS No. 16, “Property, Plant and Equipment” addresses the issues associated with accounting for property, plant, and equipment assets. Required: a. What are the specific issues addressed in this pronouncement and what was its purpose? b. When does IAS No. 16 indicates that items of property, plant, and equipment should be recognized as assets? Case 9-15 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Select at lease one domestic oilproducing company. (Consult the Preface for websites of companies or search for different companies.) Required: a. For the domestic companies answer the following questions for the last reporting year: i. What items of property, plant and equipment do each of the companies disclose? ii. What depreciation methods do the companies use? iii. For the oil company, are the disclosure requirements contained in SFAS No. 69 being followed? b. For the international companies answer the following questions for the last reporting year: i. What items of property, plant and equipment do each of the companies disclose? ii. What depreciation methods do the companies use? Do the companies disclose how they selected their depreciation methods? iii. Have any of the companies revalued their assets as allowed by IAS No. 16? iv. Have any of the companies changed depreciation methods as required under certain circumstances by IAS No. 16? Financial Analysis Case Assess your company’s utilization of long-term assets. Required: a. Comment on your company’s asset-replacement policy b. How is your company’s asset-replacement policy impacting its return on assets ratio? c. Compare your company’s asset utilization ratio with that of its two competitors. 20

d. What method of depreciation does your company use? e. What depreciation methods do your company’s two competitors use? Chapter 10 WWW Cases Case 10-9 Organization Costs Newatit Company spent a substantial amount of money organizing and getting ready for business. These costs are considered organization costs. Required: a. Does the incurrence of organization costs meet the definition of assets found in the Conceptual Framework? Explain. b. If organization costs are assets, would they be considered intangible assets? Explain. c. How should the cost incurred be matched against earnings under current GAAP? d. Some theorists argue that organization costs should not be amortized. Defend this position. Case 10-10 Equity Securities Garcia Co. has the following available-for-sale securities outstanding on December 31, 2013 (its first year of operations). Cost $20,000 9,500 20,000 $49,500

Rossi Corp. Stock Barker Company Stock Boliva Company Stock

Fair Value $19,000 8,800 20,600 $48,400

During 2014, Barker Company stock was sold for $9,200, the difference between the $9,200 and the “fair value” of $8,800 being recorded as a “Gain on Sale of Investments.” The market price of the stock on December 31, 2014, was: Rossi Corp. stock $19,900; Boliva Company stock $20,500. Required: a. What justification is there for valuing available-for-sale securities at fair value and reporting the unrealized gain or loss as part of stockholders' equity? b. How should Garcia Company apply this rule on December 31, 2013? Explain. c. Did Garcia Company properly account for the sale of the Barker Company stock? Explain. d. Are there any additional entries necessary for Garcia Company at December 31, 2014, to reflect the facts on the financial statements in accordance with generally accepted accounting principles? Explain. Case 10-11 Accounting for Research and Development Costs Furyk Co. is in the process of developing a revolutionary new product. A new division of the 21

company was formed to develop, manufacture, and market this new product. As of year-end (December 31, 2014), the new product has not been manufactured for resale. However, a prototype unit was built and is in operation. Throughout 2014, the new division incurred certain costs. These costs include design and engineering studies, prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and market research costs. In addition, approximately $2,000,000 in equipment (with an estimated useful life of 10 years) was purchased for use in developing and manufacturing the new product. Approximately $500,000 of this equipment was built specifically for the design development of the new product. The remaining $1,500,000 of equipment was used to manufacture the pre-production prototype and will be used to manufacture the new product once it is in commercial production. Required: a. How are “research” and “development” defined in the FASB ASC? b. What are the practical and conceptual reasons for the conclusion originally reached by the Financial Accounting Standards Board in SFAS No. 2 on accounting and reporting practices for research and development costs. c. In accordance with GAAP, how should the various costs for Furyk described above be recorded on the financial statements for the year ended December 31, 2014? Case 10-12 Accounting for Patent Infringement On June 30, 2014, your client, Steinfield Company, was granted two patents covering plastic cartons that it had been producing and marketing profitably for the past 3 years. One patent covers the manufacturing process, and the other covers the related products. Steinfield executives tell you that these patents represent the most significant breakthrough in the industry in the past 30 years. Licenses under the patents have already been granted by your client to other manufacturers in the United States and abroad and are producing substantial royalties. On July 1, Steinfield commenced patent infringement actions against several companies whose names you recognize as those of substantial and prominent competitors. Steinfield's management is optimistic that these suits will result in a permanent injunction against the manufacture and sale of the infringing products as well as collection of damages for loss of profits caused by the alleged infringement. The financial vice president has suggested that the patents be recorded at the discounted value of expected net royalty receipts. Required: a. What is the meaning of “discounted value of expected net receipts”? Explain. b. How would such a value be calculated for net royalty receipts? c. What basis of valuation for Steinfield's patents would be generally accepted in accounting? Give supporting reasons for this basis. d. Assuming no practical problems of implementation, and ignoring generally accepted accounting principles, what is the preferable basis of valuation for patents? Explain. e. What would be the preferable theoretical basis of amortization? Explain. f. What recognition, if any, should be made of the infringement litigation in the financial statements for the year ending September 30, 2014? Discuss. 22

Case 10-13 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Required: a. For the domestic companies answer the following questions for the last reporting year: i. Do the companies report any long-term investments? If so, are they classified as trading securities or held-to-maturity securities? ii. Do the companies disclose any intangible assets? If so, what categories of intangible assets are disclosed and what amortization period is being used? iii. Do the companies disclose any research and development expenses? b. For the foreign companies answer the following questions for the last reporting year: i. Do the companies report any long-term investments? If so, what valuation basis is used by each company? ii. Do the companies disclose any intangible assets? If so, what categories of intangible assets are disclosed and what amortization period is being used? iii. Do any of the companies disclose "negative goodwill"? iv. Do the companies disclose any research and development expenses? If so, have any of the companies recorded development costs as assets? Financial Analysis Case Disclosure of investments and intangibles Required: a. Review the financial statements for your company to determine if they disclose any of the following: i. Trading securities ii. Available-for-sale securities iii. Held-to-maturity securities iv. Investments accounted for by the equity method v. Intangibles b. Perform a similar analysis for your two competitor companies. Chapter 11 WWW Cases Case 11-11 Bond Balance Sheet Presentations, Interest Rate and Premium On January 1, 2014, Weiss Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount. Below are three presentations of the long–term liability section of the balance sheet that might be used for these bonds at the issue date. 1. Bonds payable (maturing January 1, 2034) $1,000,000 Unamortized premium on bonds payable 85,800 23

Total bond liability 2. Bonds payable—principal (Discounted face value $1,000,000) Bonds payable—interest (Discounted semiannual payment $55,000) Total bond liability 3. Bonds payable—principal (maturing January 1, 2034) Bonds payable—interest ($55,000 per period for 40 periods) Total bond liability

$1,085,800 142,050 943,750 $1,085,800 $1,000,000 2,200,000 $3,200,000

Required: a. Discuss the conceptual merit(s) of each of the date–of–issue balance sheet presentations shown above for these bonds. b. Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000. c. Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose: 1. The coupon or nominal rate. 2. The effective or yield rate at date of issue. d. If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest? Case 11-12 Bond Prices, Disclosure, and Retirement On March 1, 2014, Morgan Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2014, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2014. Morgan uses the effective-interest method of amortization. Bond issue costs were incurred in preparing and selling the bond issue. The bonds can be called by Morgan at 101 at any time on or after March 1, 2015. Required: a. 1. How would the selling price of the bond be determined? 2. Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold. b. What items related to the bond issue would be included in Morgan's 2014 income statement, and how would each be determined? c. Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why? d. Assuming that the bonds were called in and retired on March 1, 2015, how should Morgan report the retirement of the bonds on the 2015 income statement?

Case 11-13 Bond Amortization and Gain or Loss Recognition Part I. The appropriate method of amortizing a premium or discount on issuance of bonds is the effective–interest method. Required: a. What is the effective-interest method of amortization and how is it different from and similar to the straight–line method of amortization? b. How is amortization computed using the effective–interest method, and why and how do amounts obtained using the differ from amounts computed under the straight-line method? Part II. Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways: 1. Amortized over remaining life of old debt. 2. Amortized over the life of the new debt issue. 3. Recognized in the period of extinguishment. Required: a. Discuss the arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt. b. Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a company's financial statements Case 11-14 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. (Consult the Preface for websites of companies or search for different companies.) Required: a. For the domestic companies answer the following questions for the last reporting year: i. What is the amount of long-term debt disclosed by each of the companies? ii. Do any of the companies’ debt instruments contain conversion provisions? iii. Do any of the companies disclose short-term obligations expected to be refinanced? iv. Do any of the companies disclose contingent liabilities? If so, have any been reported as current expenses? v. Have any of the companies engaged in derivative transactions? If so, what types? b. For the international companies answer the following questions for the last reporting year: i. Are the companies disclosing the information about their financial liabilities that is required under the provisions of IAS No. 32? ii. What is the amount of long-term debt disclosed by each of the companies? iii. Do any of the company's debt instruments contain conversion provisions? 25

iv. Do any of the companies disclose contingent liabilities? If so, have any been reported as current expenses? v. Have any of the companies engaged in derivative transactions? If so, what types?. Financial Analysis Case Evaluate the use of debt. Required: a. Calculate the following ratios: i. Long-term debt-to-assets ratio ii. Interest coverage ratio iii. Debt service coverage ratio b. Calculate the same ratios for your competitor companies and comment on your company’s relative solvency and use of leverage c. Review Item 7a in your company’s and its two competitors’ 10-K reports and summarize the companies’ disclosure of information on market risk. d. Comment on your company’s comparative use of derivatives. Chapter 12 WWW Cases Case 12-8 The Impact of Changes in Rates on Deferred Tax Amounts Explain the effect that changes in income tax rates have on income tax expense for companies that have deferred income tax assets and for companies that have deferred income tax liabilities. Case 12-9 Objectives of Accounting for Income Taxes The amount of income taxes due to the government for a period of time is frequently different that the amount reported on the income statement for that period as income tax expense. Required: a. What are the objectives of accounting for income taxes in general-purpose financial statements? b. Discuss the basic principles that are applied in accounting for income taxes at the date of the financial statements to meet the objectives discussed in Part. c. Outline the procedures used in the annual computation of deferred tax liabilities and assets. Case 12-10 Temporary vs. Permanent Differences Required: a. Indicate whether each of the following independent situations should be treated as a temporary difference or as a permanent difference, and explain why.

1. Estimated warranty costs (covering a 3-year warranty) are expensed for financial reporting purposes at the time of sale but deducted for income tax purposes when paid. 2. Depreciation for book and income tax purposes differs because of different bases of carrying the related property, which was acquired in a trade-in. The different bases are a result of different rules used for book and tax purposes to compute the basis of property acquired in a trade-in. 3. A company properly uses the equity method to account for its 30% investment in another company. The investee pays dividends that are about 10% of its annual earnings. 4. A company reports a gain on an involuntary conversion of a nonmonetary asset to a monetary asset. The company elects to replace the property within the statutory period using the total proceeds so the gain is not reported on the current year's tax return. 5. Premiums on officers' life insurance policies with the company as beneficiary. 6. Interest on bonds issued by the city of Chicago. 7. Gross profits on installment sales. The company uses the accrual method for financial accounting purposes and the cash recovery method for income tax purposes b. Discuss the nature of the deferred income tax accounts and possible classifications in a company's balance sheet. Indicate the manner in which these accounts are to be reported. Case 12-11 FIN 48 Required: Discuss the requirements of FIN No. 48 “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” Case 12-12 IASC Income Tax Project In March 2009, the IASB issued an exposure draft of a revised IAS No. 12 that attempts to alleviate differences between the original IAS No. 12 and SFAS 109 FASB ASC 740). . The proposed standard retains the basic approach to accounting for income tax-to recognize now the future tax consequences of past events and transactions, rather than waiting until the tax is payable. What are the main changes contained in the proposed new standard? Case 12-13 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. (Consult the Preface for websites of companies or search for different companies.) Required: a. For the domestic companies answer the following questions for the last reporting year: 27

i. Do the amounts for income tax expense and income tax payable differ? If so, review the footnotes to determine the reason for this difference. ii. Do the companies disclose either deferred tax assets or deferred tax liabilities? iii. Do any of the companies disclose net operating loss carrybacks or carryforwards? b. For the foreign companies answer the following questions for the last reporting year: i. What method of accounting for interperiod tax timing differences are the companies using? ii. Do the amounts for income tax expense and income tax payable differ? If so, review the footnotes to determine the reason for this difference. iii. Do the companies disclose either deferred tax assets or deferred tax liabilities? iv. Do any of the companies disclose net operating loss carrybacks or carryforwards? Financial Analysis Case Analyze income tax expense and income taxes payable. Required: a. Analyze your company’s provision for income taxes and income taxes payable including: i. The amount of income taxes that would have been paid at the statutory rate and the amount actually paid ii. Changes in the deferred tax asset and liability accounts iii. Changes (if any) in the amounts of income tax carrybacks and carryforwards b. Conduct a similar analysis for your two competitor companies and discuss any differences you find. Chapter 13 Cases Case 13-09 Recording Capital Leases On January 1, 2014, Dahlgren Corporation entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Dahlgren at the end of the lease term; consequently, the criteria established for the classification as a capital lease by the lessee were met. The term of the lease is 8 years. The equal minimum lease payments are due at the beginning of each year starting on January 1, 2014. Required: a. What is the theoretical justification for requiring certain long-term leases to be capitalized by the lessee? b. How should Dahlgren account for this lease at its inception and how is the amount to be recorded determined? c. What expenses related to this lease will Dahlgren incur during the first year of the lease, and how will they be determined? d. How should Dahlgren report this lease on its December 31, 2014, balance sheet?

Case 13-10 Determining Lease Capitalization Amounts Hill Corporation, a diversified manufacturing company, has offices and operating locations in major cities throughout the United States. The corporate headquarters for Hill Corporation is located in Chicago, Illinois, and employees connected with various phases of company operations travel extensively. Corporate management is currently evaluating the feasibility of acquiring a business aircraft that can be used by company executives to expedite business travel to areas not adequately served by commercial airlines. Proposals for either leasing or purchasing a suitable aircraft have been analyzed, and the leasing proposal was considered to be more desirable. The proposed lease agreement involves a fully equipped Cessna CJ4 business jet that has a fair value of $10,000,000. This plane would be leased for a period of 10 years beginning January 1, 2014. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $1,417,800is due on January 1 of each year; the first payment is to be made on January 1, 2014. Maintenance operations are scheduled by the lessor, and Hill Corporation will pay for these services as they are performed. Estimated annual maintenance costs are $69,000. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $40, 000 annually and are included in the annual lease payment of $1,417,800. Upon expiration of the 10-year lease, Hill Corporation can purchase the CJ4 for $444,400. The estimated useful life of the plane to Hill is 10 years, and its salvage value in the used plane market is estimated to be $750,000. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2023. Hill Corporation can borrow $10,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor's implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on 10 annual net rental payments and the initial fair value of $10,000,000 for the plane. On January 1, 2014, the present value of all net rental payments and the purchase option of $444,440 is $8,888,900 using the 12% interest rate. The present value of all net rental payments and the $44,440 purchase option on January 1, 2014, is $10,222,260 using the 8% interest rate implicit in the lease agreement. The controller of Hill Corporation has established that this lease agreement is a capital lease as defined in GAAP. Required: a. What is the appropriate amount that Hill Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed? b. Assume instead that the annual lease payment is $1,417,800, that the appropriate capitalized amount for the leased aircraft is $10,000,000 on January 1, 2014, the interest rate is 9% and that the lease term is 10 years. How will the lease be reported on Hill’s December 31, 2014, balance sheet and related income statement? (Ignore any income tax implications.) Case 13-11 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. (Consult the Preface for websites of 29

companies or search for different companies.) Required: a. Review the financial statements for the three domestic companies and answer the following questions for the last reporting year: i. Do the companies disclose any capital leases of leased property? If so, are the disclosure requirements contained in SFAS No. 13 being followed? ii. Are any of the companies lessors in lease transactions? If so, do they use the salestype or direct financing method to account for their lease transactions? b. Review the financial statements for the three foreign companies and answer the following questions for the last reporting year: i. Do the companies disclose any financial leases of leased property? ii. Are any of the companies lessors in lease transactions? If so, how are they accounting for these transactions? Financial Analysis Case Use of leases Required: a. Review the financial statements of your company and its two competitors to determine if they are using leases as a part of their financing activities strategy. b. Contrast your company’s leasing strategy with those of its competitors. Chapter 14 WWW Cases Case 14-7 Pension Theory Many business organizations have been concerned with providing for the retirement of employees since the end of WWII. This concern has resulted in the establishment of private pension plans in many companies. The substantial growth of these plans, both in numbers of employees covered and in amounts of retirement benefits, has increased the significance of pension costs in relation to the financial position, results of operations, and cash flows of many companies. In examining the costs of pension plans, it is necessary to understand several concepts. The components of pension costs that the concepts represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans. Required: a. Define a private pension plan. How does a contributory pension plan differ from a noncontributory plan? b. Differentiate between “accounting for the employer” and “accounting for the pension fund.” c. Explain the terms “funded” and “pension liability” as they relate to: 1. The pension fund. 30

2. The employer. d. 1. Discuss the theoretical justification for accrual recognition of pension costs. 2. Discuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you-go) accounting for annual pension costs. Case 14-8 Pension Terminology Calculating the costs of pension plans, requires the understanding of certain terms. The components of pension costs that the terms represent must be dealt with appropriately if generally accepted accounting principles are to be reflected in the financial statements of entities with pension plans. Required; a. 1. Discuss the theoretical justification for accrual recognition of pension costs. 2. Discuss the relative objectivity of the measurement process of accrual versus cash (pay-as-you-go) accounting for annual pension costs. b. Explain the following terms as they apply to accounting for pension plans. 1. Market-related asset value. 2. Projected benefit obligation. 3. Corridor approach. c. What information should be disclosed about a company's pension plans in its financial statements and its notes? Case 14-9 Pension Concepts Duffner Corporation is a medium-sized manufacturer of paperboard containers and boxes. The corporation sponsors a noncontributory, defined benefit pension plan that covers its 250 employees. Sid Caesar has recently been hired as president of Duffner Corporation. While reviewing last year's financial statements with controller Imogene Coca, Caesar expressed confusion about several of the items in the footnote to the financial statements relating to the pension plan. In part, the footnote reads as follows. Note J. The company has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee's compensation during the last four years of employment. The company's funding policy is to contribute annually the maximum amount allowed under the federal tax code. Contributions are intended to provide for benefits expected to be earned in the future as well as those earned to date. The net periodic pension expense on Duffner Corporation's comparative income statement was $72,000 in 2012 and $57,680 in 2011. The following are selected figures from the plan's funded status and amounts recognized in the Duffner Corporation's Statement of Financial Position at December 31, 2014 ($000 omitted). Actuarial present value of benefit obligations: Accumulated benefit obligation (including vested benefits of $636) $ (870) Projected benefit obligation $(1,200) Plan assets at fair value 1,050 Projected benefit obligation in excess of plan assets $ (150) 31

Given that Duffner Corporation's work force has been stable for the last 6 years; Caesar could not understand the increase in the net periodic pension expense. Coca explained that the net periodic pension expense consists of several elements, some of which may increase or decrease the net expense. Required: a. The determination of the net periodic pension expense is a function of five elements. List and briefly describe each of the elements. b. Describe the major difference and the major similarity between the accumulated benefit obligation and the projected benefit obligation. c. 1. Explain why pension gains and losses are not recognized on the income statement in the period in which they arise. 2. Briefly describe how pension gains and losses are recognized. Case 14-10 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. Required: a. Review the financial statements for the three domestic companies and answer the following questions for the last reporting year: i. Do the companies report any pension expense? ii. If so, do the companies have defined contribution or defined benefit pension plans? iii. Do the companies disclose any other expenses associated with postretirement benefits? b. Review the financial statements for the three foreign companies and answer the following questions for the last reporting year: i. Do the companies report any pension expense? ii. If so, do the companies have defined contribution or defined benefit pension plans? iii. Do the companies disclose any other expenses associated with postretirement benefits Financial Analysis Case Analyze retirement provisions. Required: a. Review the financial statements of your company and its two competitors to determine if they disclose information on pension or other postretirement benefits. b. Discuss any differences that you find.

Chapter 15 WWW Cases Case 15-14 Effects of Transactions The transactions listed below relate to Rice Inc. You are to assume that on the date on which each of the transactions occurred, the corporation's accounts showed only common stock ($100 par) outstanding, a current ratio of 2.7:1, and a substantial net income for the year to date (before giving effect to the transaction concerned). On that date, the book value per share of stock was $151.53 (Book value per share = total stockholders’ equity – preferred stock/common shares outstanding). Each numbered transaction is to be considered completely independent of the others, and its related answer should be based on the effect(s) of that transaction alone. Assume that all numbered transactions occurred during 2014 and that the amount involved in each case is sufficiently material to distort reported net income if improperly included in the determination of net income. Assume further that each transaction was recorded in accordance with generally accepted accounting principles and, where applicable, in conformity with the allinclusive concept of the income statement. For each of the numbered transactions you are to decide whether it a. Increased the corporation's 2014 net income. b. Decreased the corporation's 2014 net income. c. Increased the corporation's total retained earnings directly (i.e., not via net income). d. Decreased the corporation's total retained earnings directly. e. Increased the corporation's current ratio. f. Decreased the corporation's current ratio. g. Increased each stockholder's proportionate share of total stockholders' equity. h. Decreased each stockholder's proportionate share of total stockholders' equity. i. Increased each stockholder's equity per share of stock (book value). j. Decreased each stockholder's equity per share of stock (book value). k. Had none of the above effects. Required: List the numbers 1 through 9. Select as many letters as you deem appropriate to reflect the effect(s) of each transaction as of the date of the transaction by printing beside the transaction number the letter(s) that identifies that transaction's effect(s). 1. _____ In January, the board directed the write-off of certain patent rights that had suddenly and unexpectedly become worthless. 2. _____ The corporation sold at a profit land and a building that had been idle for some time. Under the terms of the sale, the corporation received a portion of the sales price in cash immediately, the balance maturing at 6-month intervals. 33

3. _____ Treasury stock originally repurchased and carried at $127 per share was sold for cash at $153 per share. 4. _____ The corporation wrote off all of the unamortized discount and issue expense applicable to bonds that it refinanced in 2014. 5. _____ The corporation called in all its outstanding shares of stock and exchanged them for new shares on a 2-for-1 basis, reducing the par value at the same time to $50 per share. 6. _____ The corporation paid a cash dividend that had been recorded in the accounts at time of declaration 7. _____ Litigation involving Rice Inc. as defendant was settled in the corporation's favor, with the plaintiff paying all court costs and legal fees. In 2010, the corporation had appropriately established a special contingency for this court action. (Indicate the effect of reversing the contingency only.) 8. _____ The corporation received a check for the proceeds of an insurance policy from the company with which it is insured against theft of trucks. No entries concerning the theft had been made previously, and the proceeds reduce but do not cover completely the loss. 9. _____ Treasury stock, which had been repurchased at and carried at $127 per share, was issued as a stock dividend. In connection with this distribution, the board of directors of Rice Inc. had authorized a transfer from retained earnings to permanent capital of an amount equal to the aggregate market value ($153 per share) of the shares issued. No entries relating to this dividend had been made previously. Case 15-15 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. (Consult the Preface for websites of companies or search for different companies.) Required: a. Review the financial statements for the three domestic companies and answer the following questions for the last reporting year: i. What components of stockholders' equity do each of the companies disclose? ii. Do the companies have preferred stock shares outstanding? If so, what special features do these shares contain? iii. Do any of the companies report treasury shares? If so, do the companies disclose the reason for reacquiring the shares? iv. Do the companies disclose any stock compensation plans? If so, are they reporting such plans under the fair value or intrinsic value methods? What was the value of 34

compensation expense measured for any outstanding stock option plans? b. Review the financial statements for the three foreign companies and answer the following questions for the last reporting year: i. What components of stockholders' equity do each of the companies disclose? ii. Do the companies have preferred stock shares outstanding? If so, what special features do these shares contain? iii. Do any of the companies report treasury shares? If so, do the companies disclose the reason for reacquiring @@@acquiring?@@@the shares? Financial Analysis Case Analyze the return to stockholders. Required: a. Calculate the following ratios: i. Return on common stockholders’ equity ii. Common stock earning leverage ratio iii. Financial structure ratio b. Calculate the same ratios for your two competitor companies and discuss the relative performance of the three companies from the viewpoint of common stockholders. Chapter 16 WWW Cases Case 16-11 Segment Reporting The Securities and Exchange Commission staff has issued guidelines for companies struggling with the problem of breaking up their business into industry segments for their annual reports. The staff noted that the process is a subjective task that “to a considerable extent, depends on the judgment of management but that companies should consider various factors to determine whether products and services should be grouped together or reported as segments. Required: a. What does financial reporting for segments of a business enterprise involve? b. Discuss the reasons for requiring financial data to be reported by segments. c. Discuss the possible disadvantages of requiring financial data to be reported by segments. d. Discuss the accounting difficulties inherent in segment reporting. Case 16-12 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies and three international companies. (Consult the Preface for websites of companies or search for different companies.) Required: 35

a. Review the financial statements for the three domestic companies and answer the following questions for the last reporting year: i. Have the companies issued a consolidated financial statement? If so, do they report goodwill? And, if so, over what period is goodwill being amortized? ii. Have the companies engaged in any foreign currency translation transactions? iii. Do the companies report segmental information? b. Review the financial statements for the three foreign companies and answer the following questions for the last reporting year: i. Have the companies issued a consolidated financial statement? If so, do they report goodwill? And, if so, over what period is goodwill being amortized? ii. Have the companies engaged in any foreign currency translation transactions? iii. Do the companies report segmental information? Financial Analysis Case Disclosure of consolidated information Required: a. Review the financial statements of your company to determine: i. Is it a consolidated entity? ii. If so, what segmental information is disclosed? iii. Did the company experience any foreign currency gains or losses? b. Conduct a similar analysis for your competitor companies. Chapter 17 WWW Cases Case 17-11 Interim Financial Statements Newsom Corporation is preparing the interim financial data which it will issue to its stockholders and the Securities and Exchange Commission (SEC) in its 10-Q quarterly report at the end of the first quarter of the 2014 fiscal year. Newsom’s accounting department has compiled the following summarized revenue and expense data for the first quarter of the year Sales Revenue $60,000,000 Cost of Goods Sold 36,000,000 Variable Selling Expenses 1,000,000 Fixed Selling Expenses 3,000,000 Included in the fixed selling expenses was the single lump-sum payment of $2,000,000 for television advertisements for the entire year. Newsom Corporation must issue its quarterly financial statements in accordance with generally accepted accounting principles regarding interim financial reporting. Required:

a. Explain whether Newsom should report its operating results for the quarter as if the quarter were a separate reporting period in and of itself, or as if the quarter were an integral part of the annual reporting period. b. State how the sales revenue, cost of goods sold, and fixed selling expenses would be reflected in Newsom Corporation's quarterly report prepared for the first quarter of the 2014 fiscal year. Briefly justify your presentation. c. What financial information, as a minimum, must Newsom Corporation disclose to its stockholders in its quarterly reports? Case 17-12 Securities and Exchange Commission The U.S. Securities and Exchange Commission (SEC) was created in 1934 and consists of five commissioners and a large professional staff. The SEC professional staff is organized into five divisions and several principal offices. The primary objective of the SEC is to support fair securities markets. The SEC also strives to foster enlightened stockholder participation in corporate decisions of publicly traded companies. The SEC has a significant presence in financial markets, the development of accounting practices, and corporation-shareholder relations, and has the power to exert influence on entities whose actions lie within the scope of its authority. Required: a. Discuss the source of the Securities and Exchange Commission’s authority. b. What is the official role of the Securities and Exchange Commission in the development of financial accounting theory and practice? c. Discuss the relationship between the Securities and Exchange Commission and the Financial Accounting Standards Board with respect to the development and establishment of financial accounting theory and practice. Case 17-13 Securities and Exchange Commission Log onto the World Wide Web and enter the SEC's home page (http://www.sec.gov). Required: What information is contained on the SEC's home page? Case 17-14 Market Risk Log on to SEC Edgar (http://www.sec.gov/edgar.shtml) and access the 10-K annual reports for three domestic companies. Search for Item 7A under Management Discussion and Analysis. Required:

a. Summarize the information provided. Specifically: i. What does each company identify as their primary market risk exposure at the end of the current reporting period ii. How they state that they manage those exposures (such as by a description of the objectives, general strategies, and instruments, if any, used to manage those exposures)? iii. Do they identify any changes in either the primary market risk exposures or how those exposures are managed, when compared to the most recent reporting period and what is known or expected in future periods b. What method of presentation do they use to disclose the information on market risk (Tabular, sensitivity analysis or value–at-risk)? Case 17-15 Financial Analysis Log onto the World Wide Web and search for the annual reports of three domestic Fortune 1000 companies. Required: a. Review the financial statements for your companies to determine if they disclose any forward-looking information. b. If so, is this information positive or negative? Financial Analysis Case Disclosure of forward-looking information Required: a. Review the financial statements for your company to determine if they disclose any forward-looking information. b. If so, is this information positive or negative? c. Conduct a similar analysis for your two competitor companies.